We develop an empirically tractable model of the U.S. Treasury market that incorporates investors heterogeneous demand shocks and their responses to macroeconomic factors in determining equilibrium yields. Our estimated model enables us to (i) quantify investors’ sensitivities to yields and factors, (ii) decompose yield movements by investors, and (iii) analyze investor responses during specific economic episodes. First, investor demand and factor sensitivities vary significantly across sectors and market conditions, with the overall market being quite inelastic. Second, decomposing yield drivers reveals a structural shift since the financial crisis: Before 2008, foreign investors were the primary drivers of yields, but their influence has declined markedly since then, while the Federal Reserve has stepped in as a state-contingent liquidity provider. Third, contrary to conventional wisdom, we find that foreign investors do not exhibit flight-to-safety behavior for Treasuries during market turmoil; instead, domestic investors drive the countercyclical movement of Treasury prices.

We introduce a new measure of a government's fiscal position that exploits cointegrating relationships among fiscal variables. The measure is a loglinear combination of tax revenue, government spending and the market value of government debt that---unlike the debt-GDP ratio---appears stationary in the US and 15 other developed countries. A weak fiscal position must ultimately be resolved by low future returns on government debt or by fiscal adjustment, a combination of high tax growth and low spending growth. Empirically, we find that debt returns play a negligible role and fiscal adjustment predominantly consists of changes in spending growth.

Governments tend to increase their borrowing at the same time, giving rise to a global fiscal cycle. This global fiscal cycle has a large component that is unexplained by global business cycle variables. We propose a novel explanation for the emergence of the global fiscal cycle: governments’ competition over the provision of reserve assets gives rise to strategic complementarity in the issuances, even when the reserve assets are substitutes in partial equilibrium. We show our reserve-asset-competition channel explains economically significant common variation in fiscal variables, beyond the common variation induced by correlated business cycles. In doing so, our model of reserve asset demand and supply also shines light on the sources of variation in the convenience yields and seigniorage revenues earned on government debt.