Granular Treasury Demand with Arbitrageurs

The U.S. Treasury market is the benchmark fixed-income market in the world, but it is not held by a single representative investor. Money market funds, banks, insurance companies, pension funds, mutual funds, foreign official institutions, foreign private investors, hedge funds, broker-dealers, and the Federal Reserve all hold Treasuries for different reasons. This paper studies how those different investors shape Treasury yields and the transmission of monetary policy.

The central idea is that Treasury pricing depends on two forces at once. Different investor sectors have different preferred maturities and different responses to yields. Arbitrageurs then connect those segments by absorbing imbalances across the curve. Studying either side alone misses part of the mechanism.

The paper measures sector-by-maturity Treasury holdings from 2011Q4 to 2022Q4 and estimates how investor demand responds across the yield curve. The key object is not just how much each sector wants to hold in total. It is how strongly investors substitute across maturities when relative yields move.

Arbitrageurs matter because the Treasury market does not clear mechanically. When investor sectors want to move toward one part of the curve, broker-dealers and hedge funds often take the other side. That intermediation is easier at the short end, where duration risk is low, and more costly at longer maturities.

This distinction explains why Treasury-market elasticity falls with maturity. The T-bill market is highly elastic because arbitrageurs can absorb short-maturity shocks at low risk. At longer maturities, the same intermediation requires bearing more duration risk, so demand shocks have larger effects on yields. A model that estimates investor demand but omits arbitrageurs would make the bill market look implausibly inelastic.

The same mechanism changes how monetary policy affects long-term yields. When the Federal Reserve raises short rates, investors have stronger incentives to move toward short-term Treasuries. If investors substitute across maturities, arbitrageurs must absorb more long-duration risk, raising term premia. Without this cross-maturity substitution, the model predicts the opposite sign.

The takeaway is that there is no single demand curve for the Treasury market. The market is a set of investor clienteles linked by arbitrageurs with limited risk capacity. Monetary policy and debt issuance affect yields by changing which investors must hold which maturity risks.

As the Treasury market grows, understanding who absorbs new supply is as important as knowing how much supply is issued. The maturity of the debt, the identity of the marginal holder, and the capacity of arbitrageurs jointly determine how resilient the market is to shocks.