Board of Governors of the Federal Reserve System

Deterioration in Market Functioning in February and March

Between late February and early March, functioning in U.S. Treasury securities and agency mortgage-backed securities (MBS) markets became increasingly strained. Amid growing concerns about the economic implications of COVID-19, investors sought to sell large volumes of long-maturity Treasury securities and MBS and reallocate their portfolios into shorter-term, more liquid assets. While the yields on long-maturity Treasury securities initially dropped sharply, in mid-March they started to increase in the face of these strong selling pressures (figure A). Around the same time as the increase in long-maturity Treasury yields, the spreads between yields on MBS and Treasury securities of comparable duration widened sharply. Indications of severe dislocations in both markets were also present. For example, bid-ask spreads for Treasury securities and agency MBS widened significantly (figure B shows indicative Treasury bid-ask spreads).

One factor that may explain these market dislocations is the effect of widespread selling of Treasury securities and MBS to primary dealers, who intermediate a large proportion of trading in these markets. As a wide range of domestic and foreign investors (including foreign official investors) rushed to raise cash or rebalance their portfolios by selling assets, dealers took large amounts of less liquid securities, including off-the-run Treasury securities and agency MBS, onto their balance sheets. At the same time, mortgage refinancing picked up, prompting substantial turnover in the MBS market. By early March, some dealers had reportedly run into balance sheet constraints that hampered their ability to purchase additional securities, leading to a deterioration in the functioning of a number of dealer-intermediated markets.

In the market for Treasury securities, liquidity conditions were particularly poor for more seasoned, or "off the run," securities. However, the most liquid parts of the market, where newly issued, or "on the run," securities are traded electronically, saw unprecedented strains: The volume of posted quotes, or "market depth," dropped sharply, while intraday bid-ask spreads were exceptionally volatile, particularly for the longest-maturity securities. These strains in the most liquid part of the market suggest that principal trading firms—market participants who specialize in high-frequency and automated intermediation—were significantly less active than usual.

Federal Reserve Policy Actions

The disruptions to the functioning of the Treasury and MBS markets were notable in view of the status of these markets as cornerstones for the operation of the U.S. and global financial systems and for the transmission of monetary policy. The Federal Reserve therefore took a series of policy measures designed to ensure the smooth functioning of these markets. These measures included the expansion of repurchase operations, an increase in purchases of Treasury and agency MBS securities, the expansion of financing arrangements for primary dealers, and a temporary change to the regulatory capital requirements of bank holding companies and depository institutions.

Beginning March 9, 2020, following a directive from the Federal Open Market Committee (FOMC), the Federal Reserve Bank of New York's Open Market Desk increased the size of overnight and term repurchase operations in order to ensure that the supply of reserves remained ample and to support the smooth functioning of the markets in which primary dealers obtain a substantial proportion of their short-term funding.¹ These changes expanded the supply of short-term funding available to primary dealers to finance their increased holdings of Treasury securities and agency MBS at a time when funding costs from other sources were increasing. Further, on March 12, the Desk introduced new weekly recurring one- and three-month term repurchase agreement (repo) operations of up to $500 billion to address the disruption in Treasury financing markets.² Finally, on March 16, the Desk introduced a second daily overnight repo operation and increased the amount offered in each to $500 billion.³ Usage of Federal Reserve repo operations peaked on March 17, with overnight and term repo outstanding of $496 billion, and has since fallen to $167 billion as funding strains have eased. In light of more stable repo market conditions, on May 4, the Desk returned to once daily overnight repo operations.⁴ Further, on May 14, the Desk discontinued its three-month term repo operations.⁵

Despite the much larger volume of repo operations during the week of March 9, strains in Treasury and agency MBS markets continued to build. Beginning in mid-March, therefore, the FOMC directed the Desk to purchase Treasury securities and agency MBS in order to support smooth market functioning. On March 15, the FOMC directed the Desk to increase its holdings of Treasury securities by at least $500 billion and of agency MBS by at least $200 billion, with purchases to take place across maturities.⁶ To provide greater flexibility in addressing the strains, on March 23, the FOMC authorized purchases of these securities in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions. The securities targeted for purchase were also expanded to include agency commercial MBS. Since mid-March, the Desk has purchased approximately $1.6 trillion and $719 billion of Treasury securities and agency MBS, respectively.⁷ The daily amounts of purchases peaked at approximately $75 billion and $41 billion for Treasury securities and agency MBS, respectively, in late March before being reduced in stages to the current average daily amounts of around $4.0 billion for Treasury securities and $4.5 billion for agency MBS (including reinvestments). These purchases helped reduce financial market volatility by providing a predictable source of demand for these securities and by taking up some of the inventories from dealers' balance sheets.

On March 17, the Board, with the approval of the U.S. Treasury Secretary, established the Primary Dealer Credit Facility (PDCF) to provide primary dealers with access to term funding against a broad range of collateral.⁸ The PDCF helped alleviate funding pressures faced by primary dealers by allowing them to source financing more easily for their increased securities holdings. The amount of PDCF loans outstanding peaked at around $35 billion in mid-April but has since declined to around $6 billion.

On March 31, the Federal Reserve announced the establishment of the temporary FIMA (Foreign and International Monetary Authorities) Repo Facility to allow FIMA account holders, which consist of central banks and other international monetary authorities with accounts at the Federal Reserve Bank of New York, to exchange their Treasury securities for U.S. dollars.⁹ This facility allows foreign official institutions to raise U.S. dollars, if needed, without having to sell Treasury securities in the open market during periods of heightened volatility or impaired market functioning. Since its inception, take-up of the facility has been modest, as stresses in the U.S. Treasury market have declined.

On April 1, the Federal Reserve released an interim final rule indicating that holdings of U.S. Treasury securities and deposits at Federal Reserve Banks by bank holding companies would be excluded from the calculation of the supplementary leverage ratio (SLR) until March 31, 2021.¹⁰ Further, on May 15, 2020, the federal bank regulatory agencies (the Board of Governors, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency) released an interim final rule allowing depository institutions that are subject to the SLR the option to similarly exclude U.S. Treasury securities and deposits at Federal Reserve Banks from their SLR calculations through March 31, 2021.¹¹ These temporary exemptions are expected to ease liquidity pressures for primary dealers and depository institutions subject to these leverage ratios by providing them with greater flexibility to intermediate trades with clients in the presence of temporarily larger inventories of Treasury securities.

Improvements in Market Functioning

Since the announcement of these policy actions, trading conditions in the markets for Treasury securities and MBS have improved steadily. The purchases of Treasury securities and agency MBS contributed to the subsequent decline in primary dealers' inventories (figure C). Bid-ask spreads have narrowed, particularly in the case of on-the-run Treasury securities, while MBS spreads have also come down from their peaks in mid-March. In addition to the Federal Reserve's actions, the passage of the CARES Act (Coronavirus Aid, Relief, and Economic Security Act), together with an improvement in sentiment among investors regarding the economic implications of COVID-19, likely contributed to the improvement in market functioning. In late May, these inventories temporarily increased to levels previously seen in March, largely because of increased dealer holdings of Treasury bills. However, Treasury markets did not exhibit a recurrence of the notable strains in trading conditions witnessed earlier this year.

Although trading conditions have improved substantially since mid-March, bid-ask spreads for longer-maturity and off-the-run Treasury securities remain wider than in mid-February. Market depth for on-the-run securities remains low, particularly for longer-maturity securities. MBS market functioning and liquidity have largely returned to pre-February norms, though strains remain in some less liquid parts of the market.

The Size of the Federal Reserve's Balance Sheet Has Increased Considerably

In response to the financial and economic disruptions caused by the COVID-19 pandemic, the Federal Reserve has eased the stance of monetary policy and has deployed various tools to promote smooth functioning of financial markets and the flow of credit to households and businesses. This discussion reviews the implications of these actions for the Federal Reserve's balance sheet.

To support the smooth functioning of those credit markets that are critical for the economy, the Federal Reserve purchased Treasury securities and agency residential and commercial mortgage-backed securities (MBS), expanded repurchase agreement (repo) operations, and introduced several credit and liquidity facilities. As a result of these actions, the size of the Federal Reserve's balance sheet increased from $4.2 trillion at the beginning of 2020, approximately 19 percent of U.S. nominal gross domestic product (GDP), to $7.2 trillion in June 2020, approximately 33 percent of U.S. nominal GDP.¹ The $3 trillion increase in the size of the balance sheet was driven by asset purchases and other extraordinary actions (figure A).²

A. Balance sheet comparison

Open Market Operations, the Discount Window, and U.S. Dollar Liquidity Swap Lines

Since the beginning of 2020, System Open Market Account holdings of Treasury securities and agency MBS increased by $1,805 billion and $427 billion, respectively.³ The markets for both Treasury securities and agency MBS play a critical role in the U.S. economy, and the Federal Reserve's purchases have fostered a substantial improvement in the functioning of these markets and the conditions prevailing in them.⁴

Furthermore, to address strains in short-term U.S. dollar funding markets, the Federal Reserve Bank of New York's Open Market Desk expanded its offerings of overnight and term repo operations. The amount of repos outstanding reached a peak of $442 billion in mid-March. Subsequently, given the improvement in funding market conditions, the Desk announced several reductions in the frequency of repo operations. As of June 3, all repos outstanding had declined to $212 billion, lower than the amount outstanding early in the year, amid substantial increases in reserves and improved funding market conditions.

On March 15, the Federal Reserve announced changes to the discount window and encouraged depository institutions to use the discount window to meet unexpected funding needs and support the flow of credit to households and businesses.⁵ The changes include lowering the primary credit rate by 150 basis points to 0.25 percent and extending borrowing terms for up to 90 days. The total outstanding discount window primary credit borrowing peaked at around $51 billion in late March and has since declined to $11 billion in June. Furthermore, the Federal Reserve maintains standing dollar liquidity swap line agreements with the central banks of several countries and instituted temporary agreements with the central banks of additional countries. After initially ramping up to $439 billion in March and April, the total agreements outstanding stayed mostly flat in May to reach $447 billion as of June 3 (figure B).

Lending Programs and Liquidity Facilities under Section 13(3) of the Federal Reserve Act

In addition to the open market operations and initiatives described earlier, the Federal Reserve further expanded measures to enhance liquidity and the flow of credit to U.S. households and businesses. Under the authority of section 13(3) of the Federal Reserve Act, with the approval of the Secretary of the Treasury, the Federal Reserve Board implemented various measures in response to intensified stresses in several markets.⁶ The combined size of the Money Market Mutual Fund Liquidity Facility and the Primary Dealer Credit Facility increased to $86 billion in April, but the size of the facilities declined to $36 billion by June 3. The combined size of other facilities, such as the Paycheck Protection Program Lending Facility, the Commercial Paper Funding Facility, the Secondary Market Corporate Credit Facility, and the Municipal Liquidity Facility, has been steadily rising and reached $65 billion as of June 3 (figure C).⁷

C. Liquidity and credit market facilities

The Expansion of Total Assets Led to Higher Reserve Balances Held by Depository Institutions

The increase in the Federal Reserve's assets led to a commensurate increase in the size of liabilities on the Federal Reserve's balance sheet. The expansion of total assets from the outright purchases and other actions resulted in reserve balances of $3.3 trillion, an increase of $1.7 trillion from the beginning of the year. Additionally, several nonreserve liabilities increased. In March and April, Federal Reserve notes grew faster than normal, partially in response to the COVID-19 pandemic, and reached $1.9 trillion, an increase of $144 billion from the beginning of the year.

Furthermore, the U.S. Treasury's General Account (TGA) at the Federal Reserve, which the Treasury uses to receive taxes and proceeds of Treasury auctions and to process the government's outlays, increased substantially. At the beginning of 2020, the TGA balance was approximately $400 billion. In preparation for the fiscal spending related to the CARES Act (Coronavirus Aid, Relief, and Economic Security Act) and other stimulus measures, the TGA balance reached a high of $1.4 trillion on June 3 (figure D).⁸