We show a significant loss in U.S. Treasury market functionality when intensive use of dealer balance sheets is needed to intermediate bond markets, as in March 2020. Although yield volatility explains most of the variation in Treasury market liquidity over time, when dealer balance sheet utilization reaches sufficiently high levels, liquidity is much worse than predicted by yield volatility alone. This is consistent with the existence of occasionally binding constraints on the intermediation capacity of bond markets.

This paper studies how Treasury market dynamics depend on adjustments to the central bank balance sheet. We introduce a dynamic model of Treasury bonds with traditional and shadow banks. In the model, both Treasury and repo market disruptions arise as a joint consequence of three frictions: (i) balance sheet costs, (ii) intraday reserves requirements, and (iii) imperfect substitutability between repo and deposits. Our model highlights the critical role of both sides of the central bank's balance sheet as well as agents' anticipation of shocks and policy interventions in matching observed market dynamics.

We analyze how external and internal constraints impact arbitrageurs during market turmoil by exploiting the 2020 Treasury market shock. Using regulatory filings, we find that hedge funds reduced arbitrage activities and increased cash holdings despite low investor redemptions and stable funding. Creditors' regulatory and liquidity constraints were not passed on to funds through uncleared bilateral repo, the predominant financing source for fixed income hedge funds. Fund-creditor borrowing data reveal more regulated dealers provided, and more important clients received, disproportionately higher funding. Value-at-risk reported by funds suggests internal risk limits were binding. Our results show arbitrageur risk constraints can amplify market instability even when external financing remains resilient.