Something unprecedented happened in the U.S. Treasury market in March 2020, as the COVID-19 pandemic was shutting down the global economy. Instead of rallying as they always had during periods of stress, Treasuries — the gold standard of safe assets, the instruments investors usually flee to in times of crisis — experienced a sudden, dramatic price crash at longer maturities.

During the 2008 financial crisis and every other major stress episode in recent memory, Treasury prices surged as investors sought refuge in a “flight to safety.” March 2020 broke the mold. Foreign investors and mutual funds each sold over $250 billion of longer maturity Treasuries in the first quarter — an order of magnitude more than in any previous quarter — converting the securities into cash (bank deposits) and cash equivalents such as T-bills. Surprisingly, a large part of their sales were not driven by immediate liquidity needs: mutual funds sold 50% more Treasuries than they needed to satisfy investor redemptions. This “dash for cash” had never been observed before. 

What could cause investors to rush out of the safest market in the world? The fact that much of the selling was preemptive is a crucial clue. It points to a dangerous interaction between three features of modern safe asset markets: investors who value Treasuries for their safety, investors who value them for their liquidity, and dealers constrained by post-crisis regulation.

There are two archetypes of Treasury investors. “Safety investors” — think pension funds — hold Treasuries to balance risk in a diversified portfolio. When stock markets tumble, they want to hold more Treasuries, creating the familiar flight-to-safety rally. “Liquidity investors” — think mutual funds — hold Treasuries so they can quickly raise liquidity to satisfy investor redemptions without having to sell less liquid investments at a loss. Historically, these two groups form a natural partnership, especially during times of stress: when liquidity investors need to sell, safety investors want to buy. Why did this not work out in March 2020?

The answer lies in how the Treasury market actually works. Dealers are the essential shock absorbers between investors selling and buying of longer maturity Treasuries, and they carry any imbalance between investor supply and demand as inventory. But post-2008 regulations, particularly the Supplementary Leverage Ratio (SLR), have made this role increasingly costly. The SLR is an unweighted capital requirement that — unlike risk-based capital rules — treats Treasuries identically to risky loans. Every bond a dealer holds consumes balance sheet space regardless of how safe it is. The larger the dealer's inventory, the more expensive it becomes to absorb additional sales.

Even though safety investors and liquidity investors are natural trading partners, when safety investors only absorb part of the selling, the remainder lands on dealer balance sheets — and that is where the trouble starts. The dealers end up as the marginal buyer and their demand is less and less elastic the more inventory they hold which creates a dangerous feedback loop. If liquidity investors expect dealer balance sheets to be full tomorrow (or in the near future), they know prices tomorrow will be depressed. That makes preemptive selling today more attractive for any liquidity investor who thinks they may face redemptions tomorrow. But if many liquidity investors think this way simultaneously, their collective selling is precisely what fills up dealer balance sheets and drives down future prices. The fear becomes self-fulfilling and we observe a market run, analogous to a classic bank run.

Whether the market tips into a run depends on the level of liquidity risk — the probability that a liquidity investor will face redemptions soon. When liquidity risk is low, investors have little reason to sell preemptively and the market functions normally. But once liquidity risk crosses a critical threshold, the equilibrium flips: all liquidity investors sell, prices drop precipitously, and the market breaks down.

But what does the standard flight-to-safety demand have to do with this? Surprisingly, it can be the catalyst that pushes a fragile market over the edge. When safety investors buy longer maturity Treasuries during a stress episode, two things happen. First, today’s price rises. Second, dealer balance sheets are relieved — safety investors take bonds off dealers' hands — which supports tomorrow's price as well. The first effect is destabilizing: a higher price today tempts liquidity investors to sell now rather than risk selling later. The second effect is stabilizing: a better price tomorrow makes holding on less risky.

Which effect dominates depends on the inherent fragility of the market, driven by dealer constraints. If constraints are loose then the market is relatively stable and only tips in high-stress situations where liquidity investors are very likely to face redemptions tomorrow. In that case, tomorrow's price weighs heavily on their mind, and knowing that today's flight to safety buffers tomorrow's price calms them down. Flight-to-safety prevents a dash for cash. But if dealer constraints are tight then the market is fragile and already tips in moderate-stress situations where liquidity investors are unlikely to face redemptions tomorrow. Under these circumstances, liquidiy investors care most about locking in today’s elevated price — and the flight-to-safety pushes it higher still. This is how flight-to-safety triggers a dash for cash.

This explains why the 2008 and 2020 crises played out so differently. In 2008, dealers faced few balance sheet constraints. The market was stable, flight-to-safety operated normally, and Treasury prices rallied. By 2020, post-crisis regulation had tightened dealer constraints considerably. The pandemic created an unusually large and sudden demand for cash and cash equivalents. The Treasury market had crossed into fragile territory, and the same flight-to-safety forces that stabilized it in 2008 now destabilized it.

The Federal Reserve’s response illustrates a key policy lesson. The Fed initially expanded repo lending to dealers, but this did nothing to ease the binding SLR constraint —Treasuries on dealer balance sheets count towards the SLR irrespective of how they are funded. Only when the Fed started taking Treasuries off dealer balance sheet through outright purchases and committed to maintaining the purchases as long as needed did markets stabilize. The lesson: in a market prone to self-fulfilling runs, a credible commitment to support future prices can flip the equilibrium from “run” to “hold.” But the commitment must be forward-looking. Relaxing constraints only temporarily can backfire by encouraging selling today while fears about tomorrow persist.

The structural vulnerabilities behind March 2020 are only getting worse. Federal deficits continue to expand Treasury supply while dealer balance sheet capacity has not kept pace — a gap that is widely expected to grow. Post-crisis regulation achieved its goal of making banks safer, but it created an unintended side effect: the most important market in the global financial system is now more fragile, and the very forces that typically stabilize it can, under stress, be the trigger for its breakdown.

Disclaimer: The views expressed in this column are those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of New York or the Federal Reserve System.