Study Finds Pattern of Large Price Swings Around Treasury Auctions

Treasury security prices in the secondary market decrease significantly before Treasury auctions and recover shortly after, according to a new study by researchers at the Yale School of Management and the London School of Economics.
While it is easy to understand why traders may be interested in this price pattern, it is less obvious why this is important for the U.S. Treasury Department. "Each year, the U.S. Treasury sells trillions of dollars of debt; the efficiency of their selling mechanism is obviously extremely important," said Hongjun Yan, a finance professor at the Yale School of Management. "Traditionally, to assess the issuance cost, we compare the price at which the Treasury auctions securities to dealers with a 'fair price' on the auction day. Our findings suggest that prices tend to be lower on auction days. In other words, this 'fair price' is not so fair after all," said Yan.

The study estimates that the cost borne by the Treasury Department ranges from 9 to 18 basis points of the auction size, which is an order of magnitude larger than traditional estimates. This amounts to more than half a billion dollars to issue Treasury notes alone in 2007. The issuance cost is likely to be substantially higher as the U.S. faces an unprecedented budget deficit and the Treasury Department needs to borrow more money to operate the federal government.

Treasury auctions are conducted regularly, with the exact dates and amounts announced in advance. It is often believed that these anticipated events in a liquid financial market like the Treasury market should have trivial impact on prices. However, examining Treasury data from January 1980 through June 2008, the authors find that auctions significantly affect prices in the secondary Treasury, repo, and equity markets, during the days around auctions. For example, the yield of 2-year notes increases, on average, by 2.53 basis points during the five days before auction, but decrease by 2.32 basis points during the five days after.

The authors attribute the price dip and recovery pattern, in part, to primary dealer's limited capacity to bear risk. In order to participate in Treasury auctions and submit competitive bids, they usually hedge part of their risk by short selling similar securities in the secondary market before auctions. In addition, the evidence that markets can't absorb anticipated shocks repeatedly, suggests that end investors' capital is slow moving.

"It isn't clear how the issuance cost can be reduced through better designs of the Treasury issuance mechanism, but recognizing this cost is an essential first step to assess and improve its efficiency," said Yan. "Our study at least offers some clue: it suggests that the Treasury can reduce the issuance costs by reducing auction sizes and increasing the frequency at which they hold auctions. This part of the research is still on-going." 

Download the working paper "Anticipated and Repeated Shocks in Liquid Markets" by Dong Lou (London School of Economics), Hongjun Yan and Jinfan Zhang (Yale School of Management).