Anomalies in US Treasury Bond Prices During Auction Weeks

In today's post, we dive into the details of price return anomalies of the US Treasury bonds during periods preceding and following bond auctions.

Treasury bond auction, as imagined by DALL-E

We've studied the price return anomalies of US Treasuries during the weeks when Treasury bond auctions are typically held.

First, we started by observing the mechanics of the US Treasury bond auctions and discovered the critical role of Primary Dealers in that process.

Primary Dealers play a crucial role in US Treasury bond auctions, serving as a bridge between the government and investors. Here's a detailed description of their functions:

1. Bidding and Buying: Primary Dealers are required to participate in all US Treasury auctions, which include Treasury bonds, notes, and bills. They submit competitive bids and are responsible for purchasing a significant portion of each auction. Their active participation helps ensure a strong demand for Treasury securities, leading to the successful funding of government operations.

2. Market Liquidity and Pricing: By actively trading Treasury securities, Primary Dealers contribute to the liquidity and depth of the secondary market. This activity aids in establishing a clear and continuous pricing benchmark for these securities, which is essential for both investors and the Treasury itself. Their involvement supports the stability and efficiency of the broader market.

3. Distribution Network: Primary Dealers distribute Treasury securities to a wide range of investors, including institutions and individuals. Their extensive networks help disseminate these securities more broadly, enhancing access and participation from various market sectors.

4. Market Intelligence and Advice: They provide the Treasury with valuable market insights and feedback regarding the demand, valuation, and market conditions for Treasury securities. This information can influence the Treasury's decisions on issuing new securities, the terms of auctions, and overall debt management strategies.

5. Monetary Policy Implementation: Primary Dealers also play a role in the implementation of monetary policy. The Federal Reserve conducts open market operations with these dealers, buying and selling Treasury securities to manage the money supply and influence interest rates. This interaction helps the Federal Reserve achieve its monetary policy objectives.

Overall, Primary Dealers are vital to the efficient functioning of the Treasury bond market and the broader financial system, facilitating the government's financing needs while supporting monetary policy execution and market stability.

Thanks to the knowledge about the importance of PDs in that process, we focused our review of papers on the possible impact on the bond market during periods near the scheduled bond auctions. Our search led us to the following studies:

1. Inventory Management by Treasury Dealers: A study on U.S. Treasury dealer positions from 1990 to 2006 shows that dealers take a large share of Treasury issuance into their inventory during auction weeks. This action, while not significantly hedged with futures, suggests that dealers may offload some inventory ahead of auctions, potentially affecting market prices and yields. Dealers are compensated for the risk associated with these inventory changes through price appreciation in the subsequent week (Fleming & Rosenberg, 2007).

2. Pre-Auction Short Positions and Bidding Behavior: Research modeling the uniform-price US Treasury security auction finds that a primary dealer's pre-auction short position significantly impacts their bidding behavior. Dealers with larger pre-auction short positions are more likely to demand the auctioned security and assign lower values to it, which could influence market dynamics and Treasury yields ahead of auctions (Tchuindjo, 2015).

3. Impact of Treasury Auctions on Futures Market: There is evidence that auctions of U.S. Treasury securities significantly impact the 10-year Treasury note futures market. The behavior of primary dealers, especially when auction demand increases while holding a short futures position, suggests that primary dealers adjust their positions ahead of auctions. This can lead to spikes in Treasury yields before auctions and a fall after the auction as they buy back short futures hedges (Smales, 2019).

4. Dealer's Informational Advantage and Market Behavior: Dealers' informational advantages can impact their bidding behavior and market outcomes. This includes strategic trading, where some bidders might reduce their demand in the days leading to the auction, potentially contributing to changes in yields before and after Treasury auctions (Hortaçsu & Kastl, 2012).

After reviewing the mentioned papers, we've come to the conclusion that the Primary Dealers' inventory management process in such periods should affect liquidity and therefore bond price returns (and bond yields, but inversely) during the auction weeks. Since we, at TradeMachine, are market practitioners, our main concern was whether we could spot some tradable anomalies during those periods, which would potentially allow us to earn some money.

So we ran our backtesting software to find out if there are some easily observable bond price tendencies during auction weeks. We repeated the process of looking to go long X days ahead of the auction and selling to close the trade Y days later.

Our intuition, and the testing process described above, led us to the following:

P&L and drawdown of a simple strategy: "Go long on TLT X days ahead of the auction, sell Y days after." Optimize (X, Y) for a positive return.

The average daily gain in the assessed hold periods is 0.06%, which is much better than on any random days (0.02%). This is significant; we have an anomaly. Such anomalies are basic building blocks of our trading strategies. When we trade around such anomalies, we can have an edge (it's not always the case, since markets are inherently competitive, but it's a good topic for another post).

Based on this analysis, we decided that it's worth trying to build some strategies around this concept.

As usual, seasonal tendencies are important, but we need to add some technical parameters to ensure the strategy returns are good enough to cover transaction costs, spread, and our exposure risk.

Thankfully we were able to do so, so we can introduce the following strategy available to our paid subscribers: