why is there a higher demand for on the run treasuries rather than off the run treasuries, (leading to the depression of off the run treasury prices and higher yields)?
Think Recent. The logic is actually somewhat circular but the answer is simply liquidity. There isn’t anything really much deeper. The market generally decides what the on-the-run bond is. Think about this way. when bonds get issued they trade around, then eventually they find a home. Older issues of bonds in general tend not to trade as much because they find a nice place to rest, like a mutual fund who just parks it. Treasuries take longer to find homes. So if liquidity is something you need in your portfolio, you are generally going to always want the on-run-the-issue, which will alter the yields of the bonds in the market. Make sense?
to put this into context: that was the initial strategy that LTCM employed. They were essentially long the spread between on-the-runs vs off-the-runs. With on-the-run demanded a lower yield (since prices are generally higher with higher demand/liquidity), they were short the on-the-run Treasuries while long off-the-runs and they capture this arbitrage as the yields narrow and converge.
Good point about LTCM. Back in my intern days on an Interest Deriv Desk, we use to always roll into the run issues. Got to keep your hedges liquid!