As Treasury is looking to refinance significant portion of it’s short term treasuries, investors demand will remain a question. It was mentioned multiple times over last tow years that China significantly reduced their treasury holdings. More recently we seen Japan which had largerest drop in US treasury holdings since 2022. There is also popularization of treasury futures to gain duration exposure through easier execution and more flexible accedd to leverage. This causes flattening of the cash Treasurties demand amongst fixed income funds which we see post 2020. This reduced bond managers demand for cash bonds, increase the risk of disorderly basis-trade unwind and exacerbate illiquidity in the off-the-run treasuries. Also many bond mangers enhancing their returns through credit, which often leads to duration mismatch typically adjusted through treasury futures. Because of reduced demand, the dealers who underwrite treasurities are now holding near record high invesntories relative to total debt outstanding. As their capacity is getting constrained, this leads to deterioration in liquidity.
It’s important to understand chaning Auction Dynamics and Primary Dealer Strain. Recent auction results have shown increasing tail sizes and weaker bid-to-cover ratios, particularly in the long end of the curve. This reflects growing supply indigestion, especially as the Treasury ramps up issuance to fund persistent deficits. Primary dealers, already facing balance sheet constraints and rising financing costs due to tighter regulatory capital requirements (like Basel III endgame discussions), are absorbing more unsold inventory—heightening liquidity stress in off-the-run Treasuries.
Recently, money market funds (MMFs) have attracted significant inflows, sharply outpacing growth in traditional bank deposits. This shift indicates public moving their assets from banks to MMFs which invest in short-term, high-yielding investments, such as Treasury bills and repurchase agreements (repos). On the other hand banks disappointed savers as for too long they avoided to raise deposit rates as they tried to avoid minimizing the carry rate for deposits. As money market funds gain assets, their demand for short-duration financial products remains elevated, sustaining upward pressure on short-term rates. Meanwhile, the slower increase in bank deposits reduces banks’ demand for longer-term Treasuries, making it less likely for long-term bond yields to decline. This dynamics prevent from lowering longer rates.
Money Market Funds (MMFs) allocate their assets primarily based on yield, liquidity, and safety. When deciding between investing in the Federal Reserve’s Reverse Repurchase Agreement (RRP) facility and Treasury bills. Recently they’ve been mostly buing 1 months and 3 month bills as they continue to trade over the RRP rate, which has been reduced by the FED toward the lower bound of the FEDs policy range back in December. Unless there would be a significant increase in the rate cuts expectation leading to sudden short term yield decline, MMF are likely to keep buying bills over RRP.
In aggregate, the evolving composition of Treasury demand marked by declining foreign holdings, increased reliance on futures, and persistent dealer capacity constraints, underscores rising fragility in the Treasury market structure. As bond managers substitute derivatives for cash exposure and short-duration flows dominate, the long end of the curve is left more vulnerable to instability. This leaves Treasury market exposed to episodes of illiquidity, elevated term premia, and disorderly repricing risk. Those risks will be especially elevated if recession would materialize and the FED will try to rapidly shift its policy to monetary easing.