THE EFFECT OF SAFE ASSET SHORTAGES ON U.S. FINANCIAL MARKETS: AN EMPIRICAL ANALYSIS

Abstract

There exists a severe imbalance between the supply and demand of safe assets in the U.S. economy today. The supply of U.S. Treasuries is struggling to keep up with the ever-rising demand, as investors from around the globe increasingly seek the safety and liquidity of U.S. sovereign debt. The ensuing equilibrium response of asset prices and market behavior to this supply/demand mismatch is deemed partly responsible for many of the problems the global economy has faced in recent years, most notably the 2008 subprime mortgage crisis. Motivated by such larger-than-expected consequences of safe asset shortages, this study examines how changes in the supply of U.S. Treasuries influence investor behavior in the repo, stock, and option markets, and how safe assets affect the broader macro-economy through its role in the repo market. The main results are that both repo market trading volume and stock market trading volume increase with safe asset supply because U.S. Treasuries serve as collaterals and hedging instruments in the two markets, respectively. The analysis also suggests that the option market is in fact more correlated with the stock market than safe asset supply due to options’ primary role as hedges for stock portfolios. Lastly, the analysis provides mixed evidence on whether changes in safe asset supply affect the macro-economy through the repo market.