FEDERAL RESERVE BANK OF SAN FRANCISCO WORKING PAPER SERIES

Does Quantitative Easing Affect Market Liquidity?

Jens H. E. Christensen, Federal Reserve Bank of San Francisco James M. Gillan, University of California at Berkeley

November 2013

Working Paper 2013-26 http://www.frbsf.org/publications/economics/papers/2013/wp2013-26.pdf

The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System.

Does Quantitative Easing Aect Market Liquidity?

Jens H. E. Christensen
and

James M. Gillan

Abstract The Federal Reserves second program of large-scale asset purchases, or quantitative easingfrequently referred to as QE2included repeated purchases of Treasury inationprotected securities (TIPS). We quantify the eect QE2 had on a model-free measure of combined liquidity premiums in TIPS yields and ination swap rates. We nd that, on TIPS purchase dates, the liquidity premium measure dropped by 8 to 11 basis points depending on maturity, or about 50 percent. These eects were sustained on nonpurchase dates during most of the program. This suggests that one benet of quantitative easing is to improve market liquidity.

JEL Classication: E43, E52, E58, G12. Keywords: market liquidity, monetary policy, quantitative easing, TIPS.

The views in this paper are solely the responsibility of the authors and should not be interpreted as reecting the views of the Federal Reserve Bank of San Francisco or the Federal Reserve System. We thank Lauren Ford for excellent research assistance. We are grateful to Autria Christensen, Fred Furlong, Jose Lopez, and Nikola Mirkov for many helpful comments and suggestions. Corresponding author: Federal Reserve Bank of San Francisco, 101 Market Street MS 1130, San Francisco, CA 94105, USA; phone: 1-415-974-3115; e-mail: jens.christensen@sf.frb.org. University of California at Berkeley, California, USA; e-mail: james.gillan@berkeley.edu. This version: November 26, 2013.

Introduction

In response to the Great Recession induced by the nancial crisis of 2007-2008, the Federal Reserve quickly lowered its target policy ratethe overnight federal funds rateeectively to its zero lower bound. Despite this stimulus, the outlook for economic growth remained grim and the threat of signicant disination, if not outright deation, high. As a consequence, the Fed began purchases of longer-term securities, also known as quantitative easing (QE), as part of its new unconventional monetary policy strategy in order to push down longer-term yields and provide additional stimulus to the economy. The success of the Feds large-scale asset purchases in reducing Treasury yields and mortgage rates appears to be well established; see Gagnon et al. (2011), Krishnamurthy and Vissing-Jorgensen (2011), and Christensen and Rudebusch (2012) among others. These studies show that yields on longer-maturity Treasuries and other securities declined on announcement days where the Fed indicated it was planning to increase its holdings of longer-term securities. Such announcement eects are thought to be related to the eects on market expectations about future monetary policy and declines in risk premiums on longer-term debt securities. In addition to the announcement eects, however, it is also possible that the actual purchases of longer-term securities could aect yields by increasing market liquidity and reducing liquidity premiums, at least temporarily. In this paper, we focus on the purchase or ow eects and analyze how the Feds second QE program, henceforth QE2, which started in November 2010 and concluded in June 2011, aected the liquidity and functioning of the market for Treasury ination-protected securities (TIPS) and the related market for ination swap contracts. The unique structure of the execution of the QE2 program provides an interesting natural experiment for studying such ow eects, in that the program included biweekly purchases of TIPS with no purchases of any other type of securities on the TIPS operation dates. Equally important, no TIPS were purchased outside the TIPS operation dates. To motivate the analysis and support the view that ow eects on liquidity premiums from the QE2 TIPS purchases could exist and matter, we note that the existence of TIPS liquidity premiums is well established. Fleming and Krishnan (2012) report market characteristics of TIPS trading that indicate smaller trading volume, longer turnaround time, and wider bid-ask spreads than are normally observed in the nominal Treasury bond market (see also Campbell et al. 2009, Dudley et al. 2009, G urkaynak et al. 2010, and Sack and Elsasser 2004). However, the degree to which they bias TIPS yields remains a topic of debate because attempts to estimate the TIPS liquidity premium directly have resulted in varying results as documented in Christensen and Gillan (2012, henceforth CG). Instead, to quantify the eects of the TIPS purchases on the TIPS and ination swap market functioning, we use the sum of

TIPS and ination swap liquidity premiums identied in CG.1 The measure is model-free and provides a good proxy for the functioning of these two markets independent of the purchase programs eect on market expectations for economic fundamentals. As such, the measure is well suited to capture the changes in TIPS and ination swap market liquidity that we are interested in. Our empirical strategy is to use an event study approach where we focus on the changes in market rates from the close of the day before each TIPS purchase operation to the close of the day of the operation. In addition, we control explicitly for other sources known to aect either TIPS and ination swap market liquidity, specically, or bond market liquidity more broadly. In summary, we nd that the TIPS purchase operations had a statistically signicant and negative impact on our measure of the combined liquidity premiums in TIPS yields and ination swap rates. The eect averaged between 8 and 11 basis points depending on maturity. This decline represents close to a 50 percent reduction, suggesting that the QE2 program helped improve market functioning on the TIPS purchase operation dates by reducing liquidity premiums in these two markets. Furthermore, we construct a counterfactual estimate of what our liquidity premium measure would likely have been without the TIPS purchases. The dierence with respect to the actual realization suggests that the liquidity eect of the purchases was sustained and had an interesting U-shaped pattern with a peak impact of up to 40 basis points near the middle of the program. We interpret this nding as indicating that part of the eect from QE programs derives from improvements in the market conditions for the targeted security classes. Our paper relates directly to two recent papers on the ow eects of large-scale asset purchases. The paper closest to ours is the paper by DAmico and King (2013, henceforth DK). They nd evidence of ow eects in their analysis of the Treasury market response to the $300 billion of Treasury purchases during the Feds rst QE program.2 They report an average decline in yields in the maturity segment purchased of 3.5 basis points on days when operations occurred. Meaning and Zhu (2011) repeat the analysis of DK for the purchases of regular Treasuries included in the QE2 program. They report that a typical QE2 purchase operation reduced Treasury yields by 4.7 basis points, while the cumulative stock eect of the entire program is estimated to be 20 basis points. Due to the greater depth of the regular Treasury market, it is not surprising that we nd ow eects about twice that size in the smaller markets for TIPS and ination swaps. We also attempt to identify ow eects on TIPS prices directly by replicating the approach of DK and Meaning and Zhu (2011). However, the estimated coecients are all insignicant and frequently have the wrong sign. We argue that
1 As a derivative whose pricing is tied to TIPS, ination swaps are even less liquid and contain their own liquidity premiums for that reason. 2 These Treasury purchases were announced on March 18, 2009, and concluded by October 30, 2009.

this outcome is due to misspecication of the time xed eects in their regression analysis, which does not appropriately account for the price eect of changes to expectations about economic fundamentals on the purchase dates.3 In our analysis, we avoid the problem of how to deal with changes in expectations about economic fundamentals altogether as they cancel out in the construction of our liquidity premium measure, as shown in Section 3. The remainder of the paper is structured as follows. Section 2 details the execution of the TIPS purchases included in the QE2 program, while Section 3 describes the construction of the TIPS and ination swap liquidity premium measure derived in CG. Section 4 lays out our empirical strategy for estimating the eects of the QE2 TIPS purchases, and Section 5 presents our results. Section 6 concludes the paper. Appendices contain additional results and describe our adaptation of DKs approach.

The TIPS Purchases in the QE2 Program

In this section, we provide a brief description of the Federal Reserves QE2 program that included purchases of a sizeable amount of TIPS. The QE2 program was announced on November 3, 2010. The program expanded the Feds balance sheet by $600 billion through Treasury security purchases over approximately an eight-month period. In addition, the FOMC had already decided in August 2010 to reinvest principal payments on its portfolio of Treasury and mortgage-backed securities in order to maintain the size of the Feds balance sheet, a policy that has been continued since then. As a consequence, the gross purchases of Treasury securities from November 3, 2010, until June 29, 2011, totaled nearly $750 billion, of which TIPS purchases represented about $26 billion. The uniqueness of these TIPS purchases is evident in Figure 1(a), which shows the total book value of the Feds TIPS holdings since 2008. Both before and after the QE2 program, the Feds holdings of TIPS were very stable. The TIPS purchases included as part of the program increased the Feds holdings by 52.8 percent and brought the total close to $75 billion.4 Figure 1(b) shows the market share of individual TIPS held by the Fed at the end of QE2. Note that the purchases were not heavily concentrated in any particular TIPS, and the Feds TIPS holdings as a percentage of the stock of each security in general remained well below one-third. Rather, the low holdings and purchases of three- to ve-year TIPS stand out, as we will see later in the empirical analysis.
As the purchases of Treasuries in both the QE1 and QE2 programs were much more frequent, any bias from the misspecied time xed eects is more likely to average out in the analysis of DK and Meaning and Zhu (2011), which might explain why they get stronger results. 4 The slight decline in mid-April 2011 is due to a maturing ve-year TIPS of which the Fed was holding $2.9 billion in principal and $327 million in accrued ination compensation.
3

100

Total book value Total face value QE2 Program Market share in percent

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Market share as of Jun. 29, 2011

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(a) Value of TIPS.

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Figure 1: Feds TIPS Holdings.

Panel (a) shows the total book and face value of TIPS held in the Federal Reserve Systems Open Market Account (SOMA). The dierence between the two series reects accrued ination compensation. The data is weekly covering the period from January 2, 2008, to June 29, 2012. Panel (b) shows the market share of individual TIPS held by the Fed at the end of QE2.

The QE2 program was implemented with a very regular schedule. Once a month, the Fed publicly released a list of operation dates for the following 30-plus day period, indicating the relevant maturity range and expected purchase amount for each operation.5 There were 15 separate TIPS operation dates, fairly evenly distributed across time, each with a stated expected purchase amount of $1 billion to $2 billion. TIPS were the only type of asset purchased on these dates, and the Fed did not acquire any TIPS outside of those dates during the course of the program. Furthermore, all outstanding TIPS with a minimum of two years remaining to maturity were eligible for purchase on each operation date, so we need not account for price movements of specic securities related to the release of the operation schedules. Finally, market participants did not know in advance either the total amount to be purchased or the distribution of purchases. However, the auction results containing this information were released a few minutes after each auction. As the auctions closed at 11:00 a.m. Eastern time, investors had sucient time to process the information before the close of the market on each operation date. This motivates our use of one-day response windows, though we also consider two-day responses for robustness. Table 1 lists the 15 operation dates that targeted TIPS, the reaction of the TIPS and ination swap liquidity premium measure we want to analyze, and the response of three of the control variables in our empirical analysis. On average, the liquidity premium measure
5

The information can be found at http://www.newyorkfed.org/markets/tot operation schedule.html.

QE2 TIPS Operation Dates (1) Nov. 23, 2010 (2) Dec. 8, 2010 (3) Dec. 21, 2010 (4) Jan. 4, 2011 (5) Jan. 18, 2011 (6) Feb. 1, 2011 (7) Feb. 14, 2011 (8) Mar. 4, 2011 (9) Mar. 18, 2011 (10) Mar. 29, 2011 (11) Apr. 20, 2011 (12) May 4, 2011 (13) May 16, 2011 (14) June 7, 2011 (15) June 17, 2011 Average

TIPS Purchases (Mill.) $1,821 $1,778 $1,725 $1,729 $1,812 $1,831 $1,589 $1,589 $1,653 $1,640 $1,729 $1,679 $1,660 $1,589 $2,129 $1,730

Liquidity measure Five-year Ten-year -1.57 -3.30 5.28 -8.44 0.24 -0.69 1.61 -1.34 -1.31 3.47 0.78 -1.42 -0.69 0.82 -4.58 -3.99 1.91 -0.78 0.83 -0.22 5.25 2.43 -0.91 3.12 -3.08 -0.38 -0.70 -1.45 1.57 1.97 0.31 -0.68

Response of O-the-run VIX ten-year spread 2.26 -0.19 -0.25 -0.44 0.08 -0.40 -0.23 0.12 0.41 -0.62 -1.90 0.01 0.26 -0.15 0.46 0.66 -1.93 0.43 -1.28 -0.40 -0.76 0.88 0.38 -0.51 1.17 -0.26 -0.42 1.45 -0.88 0.80 -0.18 0.09

AAA indu. credit spread -1.85 -1.58 -1.58 -0.07 1.80 -0.66 2.58 3.98 -2.72 0.00 0.47 -0.80 4.87 2.13 -0.35 0.42

Table 1: Market Response on TIPS Purchase Operation Dates.

The table reports the amount of TIPS purchased on the 15 TIPS operation dates during the QE2 program. The table also reports the one-day response of the ve- and ten-year liquidity premium measure described in Section 3. In addition, the table shows the response of three of the daily time series used as control variables. All numbers are measured in basis points with the exception of the TIPS purchase amounts, which are reported in millions of dollars.

increased 0.31 basis point at the ve-year maturity and decreased 0.68 basis point at the tenyear maturity. However, the average changes in the control variables shown in the last three columns of Table 1 also have mixed signs, which highlights the importance of using statistical regressions to assess the eect of the QE2 TIPS purchases on our liquidity premium measure. A rst indication that the TIPS purchases could have had an impact on TIPS market functioning is provided in Figure 2, which shows the weekly average of the daily trading volume in the secondary market for TIPS as reported by primary dealers to the New York Fed; also shown is the smoother eight-week moving average. While TIPS trading volume did increase notably during the course of the program, we are interested in the ow eects; that is, the eect the purchases had on liquidity premiums in the market for TIPS and the related market for ination swap contracts on the purchase operation dates. To do so, we exploit the model-independent measure of the sum of liquidity premiums in TIPS and ination swaps described in the following section.

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Lehman Brothers Bankruptcy 15 Sept. 15, 2008 QE2 Program

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Figure 2: TIPS Trading Volume.

Weekly average of daily trading volume in the secondary market for TIPS (dashed black line) and the smoothed eight-week moving average (solid black line).

A Measure of Liquidity Premiums in TIPS and Ination Swaps

In this section, we describe how we construct the measure of liquidity premiums in TIPS yields and ination swap rates that we use as dependent variable in our empirical analysis. Since its inception in 1997, the market for TIPS has grown steadily and, as of the end of 2012, represented 7.7 percent of the total market for tradable U.S. Treasury securities.6 Unlike regular Treasury securities that pay xed coupons and a xed nominal amount at maturity, TIPS deliver a real payo because their principal and coupon payments are adjusted for ination.7 The dierence in yield between regular nominal, or non-indexed, Treasury bonds and TIPS of the same maturity is referred to as breakeven ination (BEI), since it is the level of ination that makes investments in indexed and non-indexed bonds equally protable. If TIPS provide good ination protection (i.e., they protect the value of bond investors
According to the Bureau of the Public Debt, the total outstanding notional value of TIPS was $849 billion as of the end of December 2012, which should be compared to $11.03 trillion in total marketable Treasury securities. The data are available at: www.TreasuryDirect.gov. 7 The U.S. Treasury uses the change in the headline consumer price index (CPI) to account for ination compensation.
6

portfolios when ination exceeds its expected path) and are considered valuable for that reason, TIPS yields will be low and BEI correspondingly high as investors are willing to pay a premium to avoid being exposed to ination risk. On the other hand, if TIPS suer from poor liquidity or are perceived to provide a poor hedge against positive ination surprises, TIPS yields will tend to be high and BEI correspondingly low as investors require a premium to hold TIPS in their portfolio. For a given outlook for ination, these two eects cause estimates of the liquidity premium to vary but in osetting ways, which makes it hard to identify one eect from the other by just observing nominal and real yields in isolation. The contribution of CG is to add information on so-called ination swap rates to get a handle on the size of the liquidity premiums in TIPS yields and ination swap rates jointly. In a long position of an ination swap contract, the investor pays a xed premium in exchange for a oating payment equal to the change in the consumer price index used in the ination indexation of TIPS. At inception, the xed premium is set such that the contract has a value of zero. In a frictionless world, the absence of arbitrage implies the ination swap rate must equal the TIPS breakeven ination because buying one nominal discount bond today with a given maturity produces the same cash ow as buying one real discount bond of the same maturity and selling an ination swap contract also of the same maturity. However, in reality, the trading of both TIPS and ination swap contracts is impeded by frictions, such as wider bid-ask spreads and less liquidity relative to the market for regular nominal Treasury bonds. As a consequence, the dierence between ination swap rates and BEI will not be zero, but instead represents a measure of how far these markets are from the frictionless outcome described above. Figure 3 shows this dierence at the ve- and ten-year maturity constructed using BEI from the G urkaynak, Sack, and Wright (2007, 2010) databases of nominal Treasury and real TIPS yields combined with zero-coupon ination swap rates from Bloomberg.8 Provided two assumptions are satised, namely, that (1) TIPS are less liquid than nominal Treasuries and (2) ination swaps are less liquid than nominal Treasuries, CG show that these strictly positive series represent the sum of liquidity premiums in TIPS yields and ination swap rates relative to the implicit, unobserved liquidity premiums in regular Treasury securities. Importantly, this is a model-independent result that relies only on the two assumptions above. Furthermore, CG present comprehensive evidence that both assumptions are satised; specically, market size, trading volume, and bid-ask spreads all indicate that regular Treasury securities are much more liquid than both TIPS and ination swaps. In the empirical analysis, it is the response of this liquidity measure to the TIPS purchases
As explained in CG, the ination swap market in the United States started to be active in 2004 as the underlying TIPS market became more well established. Still, the data on ination swap rates are not densely populated across maturities until late 2004. For this reason, our sample starts in 2005. See CG for details on the construction of our measure.
8

Fiveyear liquidity premium Tenyear liquidity premium

QE2 Program Rate in percent 2 Lehman Brothers Bankruptcy Sept. 15, 2008

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Figure 3: Sum of Liquidity Premiums in TIPS and Ination Swaps.

in the QE2 program that we are interested in analyzing. Importantly, in the construction of the measure, any eects of the QE2 program on bond investors view of economic fundamentals, such as future monetary policy, ination, and their implications for bond yields, will cancel as they aect ination swap rates and BEI of the same maturity in equal amounts.

Empirical Strategy

In this section, we describe how we quantify the eect of the QE2 TIPS purchases on our TIPS and ination swap liquidity premium measure. Our primary empirical strategy is to use an event study approach, where we focus on the changes in market rates from the close of the day before each TIPS purchase operation to the close of the day of the operation. The idea is to minimize the noise from other unrelated sources that might aect our liquidity measure. In addition, we need to control explicitly for sources that we do know aect the measure. We include ve variables that reect either TIPS and ination swap market liquidity, specically, or bond market liquidity more broadly. The rst variable we consider is the VIX options-implied volatility index. It represents near-term uncertainty about the general stock market as reected in options on the Standard & Poors 500 stock price index and is widely used as a gauge of investor fear and risk aversion. The motivation for including this variable is that elevated economic uncertainty would imply

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Fiveyear liquidity premium (bps) 2*VIX optionsimplied volatility (percent) Lehman Brothers Bankruptcy Sept. 15, 2008

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Figure 4: The VIX Options-Implied Volatility Index for the S&P 500.
Illustration of the VIX options-implied volatility index for the S&P 500 stock price index with a comparison to the ve-year liquidity premium measure. Note that the former is measured in percent and multiplied by two to make its scale comparable to the latter, which is measured in basis points.

increased uncertainty about the future resale price of any security and therefore could cause liquidity premiums that represent investors guard against such uncertainty to go up. As shown in Figure 4, the VIX has a high, positive correlation with our liquidity premium measure as expected. The second variable included is the yield dierence between seasoned (o-the-run) Treasury securities and the most recently issued (on-the-run) Treasury security of the same maturity. Figures 5(a) and 5(b) illustrate these series at the ve- and ten-year maturities, respectively. In each case, the o-the-run spread is compared with the corresponding liquidity premium measure of the same maturity, and in our regressions, we also match the maturity in this way. For each maturity segment in the Treasury yield curve, the on-the-run security is typically the most traded security and therefore penalized the least in terms of liquidity premiums, which explains the mostly positive spread. For our analysis, the important thing to note is that if there is a wide yield spread between liquid on-the-run and comparable seasoned Treasuries, we would expect to also see large liquidity premiums in TIPS yields and ination swap rates relative to those in the Treasury bond market, i.e., a widening of our liquidity premium measure. The third variable used is the excess yield of AAA-rated U.S. industrial corporate bonds 9

2.5

Fiveyear liquidity premium Fiveyear offtherun yield spread

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Lehman Brothers Bankruptcy Sept. 15, 2008

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(a) Five-year maturity.

(b) Ten-year maturity.

Figure 5: O-the-Run Treasury Par-Yield Spreads.

Panel (a) illustrates the yield spread between the ve-year o-the-run Treasury par yield from the G urkaynak et al. (2007) database and the ve-year on-the-run Treasury par yield from the H.15 series at the Board of Governors. Included is the ve-year TIPS and ination swap liquidity premium. Panel (b) illustrates the corresponding series at the ten-year maturity.

over comparable Treasury yields shown in Figure 6.9 We note that in choosing the maturity we face a trade-o. On one side, we would ideally like to match the maturity of our liquidity premium measure. However, the credit risk of even AAA-rated industrial bond issuers cannot be deemed negligible at a ve- to ten-year horizon. On the other hand, if we focus on very short-term debt where the credit risk is entirely negligible, we are far from the desired maturity range. We believe using the two-year credit spread strikes a reasonable balance, and the results are not sensitive to this particular choice. As the credit risk component of such highly rated shorter-term corporate bond yields is minimal, the yield spread largely reects the premium bond investors require for being exposed to the lower trading volume and larger bid-ask spreads in the corporate bond market vis-` a-vis the liquid Treasury bond market. Again, if such liquidity premiums of high-quality corporate bonds are large, we could expect both TIPS yields and ination swap rates to contain wide liquidity premiums. The fourth variable considered is the bid-ask spreads of TIPS and ination swap contracts. The microstructure frictions that such spreads represent could potentially account for a sizeable part of the variation in our liquidity premium measure and we want to control for that. Figure 7 shows the four-week moving average of bid-ask spreads as reported by Bloomberg for the most recently issued ve- and ten-year TIPS and the bid-ask spreads of inPlease note that the AAA-rated corporate bond yield data are only available until March 12, 2012, in the Bloomberg database.
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Fiveyear liquidity premium Twoyear US industrial AAArated credit spread Bear Stearns Collapse March 14, 2008 Rate in percent 2 Lehman Brothers Bankruptcy Sept. 15, 2008

Correlation = 78.9%

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Figure 6: Credit Spread of AAA-Rated U.S. Industrial Bonds.

Illustration of the two-year credit spread of AAA-rated U.S. industrial corporate bonds over the comparable two-year Treasury yield from the G urkaynak et al. (2007) database. Included is the veyear TIPS and ination swap liquidity premium. The corporate bond yields are downloaded from Bloomberg.

ation swap contracts with the same two maturities from the same source. While the bid-ask spreads of the ination swap contracts exhibit reasonable time variation at a level consistent with numbers reported elsewhere,10 the bid-ask spreads for the TIPS appear suspiciously low and stable before the spring of 2011.11 For this reason, we include the bid-ask spreads only for the ination swaps in our regressions, and similar to what we did with the o-the-run yield spreads, we use the ve- and ten-year bid-ask spreads in the ve- and ten-year liquidity premium regressions, respectively. The nal variable is the weekly average of the daily trading volume in the secondary market for TIPS as reported by the Federal Reserve Bank of New York and shown in Figure 2. We use the eight-week moving average to smooth out short-term volatility. This measure should have a negative eect on our liquidity premium measure as increases in TIPS trading volume should, in most cases, drive down TIPS and ination swap liquidity premiums. By including these ve control variables, our regression results will reveal what eect the
For example, these numbers are close to the order of transaction costs in the ination swap market reported by Fleckenstein, Longsta, and Lustig (2012) based on conversations with traders. 11 Haubrich, Pennacchi, and Ritchken (2012) report bid-ask spreads for ten-year TIPS, which are higher than the Bloomberg data, in particular around the peak of the nancial crisis in the fall of 2008 and early 2009. Unfortunately, their series ends in May 2010 and cannot be used for our analysis.
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Figure 7: Bid-Ask Spreads in the TIPS and Ination Swap Markets.

Illustration of the bid-ask spread as reported by Bloomberg for the most recently issued, or so-called onthe-run, ve- and ten-year TIPS. Shown are also the bid-ask spreads from the ination swap market for the ve- and ten-year zero-coupon ination swap contracts. All series are smoothed four-week moving averages and measured in basis points.

TIPS purchase operations had on TIPS and ination swap liquidity premiums beyond their eect on the liquidity of regular Treasury securities and corporate bonds. However, as the TIPS auction dates did not involve any purchases of regular Treasury securities, the one-day event window we use should at least minimize, if not entirely eliminate, any such feedback eects. To capture the one-day response of our liquidity premium measure to the TIPS operations, we include a standard indicator variable for the 15 TIPS purchase operations jointly. This variable allows us to capture the dierence in the closing value of the measure from the day before each TIPS operation to the day of the operation. We also explore the two-day responses to detect whether there is any reversal in the eects, which is likely because the Fed purchased regular Treasury securities on the other weekdays around the TIPS operation dates.12 Those purchases should improve the liquidity of regular Treasury securities relative to TIPS and hence put upward pressure on our liquidity premium measure. Finally, we look at the overall impact of the purchase program by constructing a coun12 Over the period from November 3, 2011, to June 30, 2011, the Fed purchased almost $725 billion of regular Treasuries, or $21 billion per week. Thus, on non-TIPS purchase dates, the Fed would be buying an average $5 billion to $6 billion of regular Treasury securities.

12

terfactual of our liquidity premium measure for the period over which the program was conducted. We use the same ve variables as in the event study and estimate the relationships derived from the period prior to the program, January 4, 2005, to November 2, 2010, to quantify what the liquidity measure would have been over the remainder of the sample had the TIPS purchases not been undertaken. The dierence between the observed series and the counterfactual represents the best guess from our regression model of the sustained eect of the TIPS purchase operations on our liquidity premium measure.

Results

In this section, we rst present empirical results from a set of baseline regressions. Second, we describe our robustness tests before proceeding to the counterfactual analysis that attempts to quantify what our liquidity premium measure would have been without the QE2 TIPS purchases. We end the section with a replication of the approach used by DK to attempt to identify any ow eects from the TIPS purchases on TIPS yields directly.

5.1

Baseline Regressions

The results for regressions with a standard indicator variable for the one-day response on the 15 TIPS purchase dates, jointly, are reported in Table 2. Regression 4 with all ve control variables is used as the baseline regression in the remainder of the section. However, regressions 1 to 3 show that the eect of the various controlling variables is robust across dierent specications of the regressions. In terms of the estimated coecients of the control variables, they all have the expected sign and are statistically signicant in all four regressions with a single exception at the veyear maturity, where the o-the-run yield spread has a negative coecient.13 As anticipated, positive changes in both the VIX and the credit spread of AAA-rated industrial corporate bonds are associated with increases in the liquidity premium measures, while increases in the daily trading volume of TIPS tend to coincide with a compression of the liquidity premium measures. Finally, an uptick in the bid-ask spreads of ination swaps is positively correlated with a widening of the liquidity premium measure. As for the one-day response dummy variable for the TIPS purchase operations, we nd that the TIPS operations during the QE2 program had a statistically signicant negative impact on the liquidity premium measures on the days of the purchases. The estimated decline in the baseline regression is 11 basis points at the ve-year maturity and 8 basis points at the ten-year maturity. Considering that the averages of the ve- and ten-year liquidity premium
This might not be surprising given that the o-the-run yield spread at the ve-year maturity is relatively modest in size and switches sign fairly frequently as seen in Figure 5(a).
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Explanatory Variables Constant VIX O-the-Run Spread AAA Credit Spread IS Bid-Ask Spread TIPS Trading Volume TIPS Purchase Dummy Adjusted R2

Regression 1 5-year 10-year -5.39 (-6.99) 2.24 (70.14) 7.68 (10.59) 0.99 (32.89)

Regression 2 5-year 10-year -7.68 (-8.54) 2.35 (59.03) -0.62 (-4.85) 10.83 (14.97) 0.30 (5.27) 0.73 (13.74)

Regression 3 5-year 10-year -5.42 (-6.39) 1.76 (33.33) -0.50 (-4.23) 0.21 (15.93) 10.85 (14.93) 0.30 (4.72) 0.73 (13.40) 0.00 (0.25)

Regression 4 5-year 10-year 2.80 (1.08) 1.36 (21.85) -0.68 (-5.89) 0.32 (19.88) 0.99 (7.60) -1.88 (-7.80) -11.03 (-3.34) 0.81 23.61 (9.67) 0.16 (2.56) 0.52 (8.87) 0.09 (5.92) 1.06 (6.07) -2.61 (-9.21) -8.08 (-2.49) 0.50

-13.75 (-3.73) 0.76

-10.36 (-2.98) 0.41

-14.59 (-3.97) 0.76

-6.79 (-2.06) 0.47

-11.45 (-3.35) 0.79

-6.76 (-2.05) 0.47

Table 2: Regression Results for Eects of TIPS Purchase Operations on the TIPS and Ination Swap Liquidity Premium Measure.
The table reports the results of regressions with the TIPS and ination swap liquidity premium measure at the ve- and ten-year horizon as the dependent variable and ve measures of market functioning as explanatory variables. Included is a standard binary dummy variable for the 15 dates on which TIPS purchase operations took place using a one-day event window. T-statistics are reported in parentheses. Asterisks * and ** indicate signicance at the 5 percent and 1 percent levels, respectively. The data are daily covering the period from January 4, 2005, to June 30, 2011, a total of 1,604 observations.

measures over the purchase period were 22.3 and 15.8 basis points, respectively, these seem like sizeable reductions of about 50 percent. This suggests that the TIPS purchases did improve TIPS and ination swap market functioning on the TIPS purchase operation dates once we control for factors that would have aected our liquidity premium measure independent of the QE2 operations. Regarding the potential for endogeneity in the regressions, if the TIPS purchases happened to reduce the bid-ask spreads of ination swaps or increase TIPS trading volume, the coecient on the purchase binary variable would underestimate the eect of the purchases because part of it would be accounted for indirectly by those variables based on the sign of their estimated coecients.14 Thus, the reported results should be viewed as conservative estimates of the eects of the TIPS purchases on our liquidity premium measures. The same holds for the result of the counterfactual analysis in Section 5.3.

5.2

Robustness Checks

In this section, we carry out a number of additional regressions as robustness checks. Our rst robustness check is to replace the one-day response indicator variable with a two14

We thank Fred Furlong for pointing this out.

14

1.2

Ratio in percent

0.0

0.2

0.4

0.6

0.8

1.0

Total market 46 year sector 810 year sector

11/23/2010

12/21/2010

1/18/2011

2/14/2011

3/18/2011

3/29/2011

4/20/2011

5/16/2011

12/8/2010

Figure 8: Ratio of TIPS Purchased Relative to Total TIPS Market.

Illustration of the ratio of TIPS purchased in each of the 15 TIPS purchase operations during the QE2 program. The solid black bars indicate the amount purchased relative to the market value of the entire TIPS market. The dark grey bars indicate the amount of four- to six-year TIPS purchased relative to the market value of all four- to six-year TIPS outstanding. The light grey bars indicate the amount of eight- to ten-year TIPS purchased relative to the market value of all eight- to ten-year TIPS outstanding.

day response variable. Using a two-day window, the results indicate that the point estimates do not change, while the statistical signicance actually increases. As such, the interpretation and the magnitude remain intact with a two-day response window. Furthermore, all other coecients barely change. In a related robustness check, we use two separate indicator variables, one that captures the reaction of the liquidity premium measure on the days with TIPS purchases, and one for the reaction the following day. If the purchases only push down the liquidity premium measure temporarily on the days of the TIPS purchases, we should expect to see a reversal already the following day, i.e., the dummy variable for the second-day response should have a positive coecient. The results for these regressions show that the TIPS purchases had longer-lasting negative eects on our measures of liquidity premiums in the TIPS and ination swap markets, as there is no positive coecient for the second-day dummy. Note, its estimated coecient has the same sign and is only slightly smaller than the coecient of the rst-day indicator variable. In the next section, we study the persistence of the purchase eects in greater detail using a counterfactual analysis. As an alternative, we weight the indicator variable for each operation date by the ratio 15

6/17/2011

1/4/2011

2/1/2011

3/4/2011

5/4/2011

6/7/2011

Explanatory Variables Constant VIX O-the-Run Spread AAA Credit Spread IS Bid-Ask Spread TIPS Trading Volume TIPS Purchase Dummy 4-6 Year Sector TIPS Purchase Dummy 8-10 Year Sector Adjusted R2

Regression 1 5-year 10-year -5.44 (-7.05) 2.24 (70.12) 7.65 (10.55) 0.99 (32.90)

Regression 2 5-year 10-year -7.71 (-8.56) 2.35 (58.95) -0.61 (-4.79) 10.82 (14.96) 0.30 (5.24) 0.73 (13.79)

Regression 3 5-year 10-year -5.44 (-6.40) 1.76 (33.28) -0.49 (-4.17) 0.21 (15.94) 10.83 (14.92) 0.29 (4.70) 0.73 (13.45) 0.00 (0.25)

Regression 4 5-year 10-year 3.16 (1.23) 1.35 (21.76) -0.68 (-5.88) 0.32 (19.96) 0.99 (7.61) -1.92 (-8.01) 8.47 (0.37) -15.37 (-3.43) 0.81 23.91 (9.82) 0.16 (2.50) 0.52 (8.83) 0.09 (6.04) 1.08 (6.20) -2.66 (-9.41) 28.61 (1.30) -14.56 (-3.31) 0.50

-9.45 (-0.37) -16.33 (-3.25) 0.76

10.51 (0.44) -14.14 (-2.99) 0.41

-9.53 (-0.38) -17.14 (-3.43) 0.76

20.31 (0.89) -10.67 (-2.38) 0.47

-3.77 (-0.16) -13.51 (-2.91) 0.79

20.37 (0.90) -10.63 (-2.37) 0.47

Table 3: Regression Results Using Maturity-Weighted Dummies.

The table reports the results of regressions with the TIPS and ination swap liquidity premium measure at the ve- and ten-year maturity as the dependent variables and ve measures of market functioning as explanatory variables. Included is a dummy variable for the 15 dates with TIPS purchase operations weighted by the amount of TIPS purchased in the 4-6 year sector relative to the total market value of all TIPS outstanding in that maturity sector. A similar dummy variable for the 8-10 year sector is also included. T-statistics are reported in parentheses. Asterisks * and ** indicate signicance at the 5 percent and 1 percent levels, respectively.

of the amount of TIPS purchased relative to the market value of the entire TIPS market. In general, the results do not dier much from our baseline result in the sense that the sign and signicance of the purchase indicator variable are little aected. As neither the amount of TIPS purchased nor the value of the TIPS market varied much across time, the total-purchase-weighted dummy exhibits only modest time variation (shown with solid black bars in Figure 8), which explains its similarity to the results from using a standard indicator variable. Instead, we include two weighted indicator variables in each regression. The rst variable is weighted by the fraction of TIPS purchased with four to six years remaining to maturity relative to the total market value of TIPS in that maturity range. The second variable repeats this using the eight- to ten-year maturity range. The weights for the two indicator variables are shown in Figure 8 with dark and light gray bars, respectively, while the regression results are reported in Table 3. We note that the indicator variable weighted based on the fraction of the four- to six-year TIPS market purchased is uniformly insignicant and most of the time has the wrong sign. On the other hand, the indicator variable weighted based on the fraction of the eight- to tenyear TIPS market purchased has the right sign and is highly statistically signicant and about

16

the same size at both maturities. Combined with the signicance of the standard indicator variables reported in Table 2, this suggests that the eects of purchases in one maturity sector may be able to spill over into neighboring maturity sectors and is consistent with similar ndings for the regular Treasury bond market reported by DK. Additionally, the estimated coecients in this case can be interpreted quite nicely. For the ten-year maturity sector, the liquidity premiums in the TIPS and ination swap markets decline by about 15 basis points for each percentage point of that segment of the TIPS market purchased. Purchases of that magnitude also depress the liquidity premium measure at the ve-year maturity by about the same magnitude. To explain the dierence in the results for the two weighted dummies, Figure 8 shows the weights for each of the 15 operation dates. Note that the purchases of four- to six-year TIPS were small, with few exceptions, even relative to the total size of that maturity sector. Hence, it appears reasonable that purchases of such tiny magnitudes have essentially no eect on the size of liquidity premiums in the markets for these securities. In the eight- to tenyear maturity sector, on the other hand, purchases were much more material and, on several occasions, represented more than 1 percent of the entire market in that maturity range. With purchases of that magnitude, it is not surprising that our liquidity measure responds, and signicantly so, in a downward direction. Ultimately, though, the interesting question is whether these signicant negative one-day eects of the 15 TIPS purchase operations during the QE2 program had a lasting downward eect on the measure of TIPS and ination swap liquidity premiums, a question we now address.

5.3

Counterfactual Analysis

To address the question of whether the TIPS purchases included in the QE2 program caused a persistent reduction in our liquidity premium measure, we use the baseline regression in Table 2 with all ve control variables included, but estimate the coecients on the sample ending on November 2, 2010, the day before the announcement of the QE2 program. By xing the coecients at those estimated values and using the subsequent realizations of the ve control variables, we get an estimate of the most likely counterfactual path for our liquidity premium measure, had the QE2 program not included TIPS purchases. Figure 9 shows the realized liquidity premium measure at the ve- and ten-year maturities as well as the corresponding estimated counterfactual paths constructed in this way. As noted in the gure, there is a sizeable wedge between the counterfactual path and the actual realization during the period from November 3, 2010, until June 30, 2011. Importantly, this counterfactual diers from a more ambitious counterfactual analysis of what would have happened without the introduction of the entire QE2 program. One key dierence is that the QE2 program almost surely aected the controlling bond liquidity variables we use. However, for the narrow 17

250

Fiveyear observed liquidity measure Fiveyear counterfactual liquidity measure

250

Tenyear observed liquidity measure Tenyear counterfactual liquidity measure

200

Rate in basis points

Rate in basis points

150

100

50

2005

2006

2007

2008

2009

2010

2011

50

100

150

QE2 Program

200

QE2 Program

2005

2006

2007

2008

2009

2010

2011

(a) Five-year liquidity premium measures.

(b) Ten-year liquidity premium measures.

Figure 9: Observed and Counterfactual Liquidity Premium Measures. question about the eect of the TIPS purchases, which accounted for less than 4 percent of the total QE2 program, we can relatively safely assume that the control measures would not have been much dierent without the TIPS purchases, maybe with the exception of the bid-ask spreads of ination swaps and the TIPS trading volume series. Still, even if there is such feedback in these two variables, it would go against us nding any eects based on the sign of their estimated coecients as explained at the end of Section 5.1. Figure 10 puts the dierence between the actual realization and the counterfactual into sharper focus for the duration of the QE2 program. Our counterfactual exercise indicates that the average of our liquidity premium measure would have been 13.7 and 11.7 basis points higher over the period of the purchase program at the ve- and ten-year maturities, respectively, and up to 40 basis points higher during the middle third of the program coinciding with turmoil about sovereign debt in southern peripheral countries in the euro area that would normally have pushed our liquidity premium measure higher. Interestingly, the realized measure declines relative to the counterfactual over the rst third of the program and then increases back to its level at the program start in a fairly symmetric fashion, indicating that market participants repeatedly priced the liquidity premiums of TIPS and ination swaps lower for the rst half of the program before gradually returning to pre-program levels. Furthermore, the estimated coecients and t for the pre-program period are consistent with those for the entire sample used in the event-study with the purchase dummy variables, conrming the robustness of the counterfactual construction.15 This suggests that, in addition to the statistically signicant one-day responses in the event study, the persistent eect of the
15

The estimated coecients are reported in Appendix A.

18

20

Fiveyear observed over counterfactual Tenyear observed over counterfactual 10 First TIPS purchase Nov. 23, 2010

Rate in basis points

40

30

20

10

50

Last TIPS purchase Jun. 17, 2011 November January March May July

Figure 10: Dierence between Observed and Counterfactual Liquidity Premium Measures.
Illustration of the dierence between the observed and counterfactual TIPS liquidity premium measure at the ve- and ten-year horizons, respectively. The sample shown covers the period from November 3, 2010, to June 30, 2011.

purchases seems to have reduced liquidity premiums in the TIPS and ination swap markets over the duration of the QE2 program. To provide context for the dierence between the observed and counterfactual path over the period from November 3, 2010, to June 30, 2011, we calculate the moving average of the in-sample tted errors from the regression used in the construction of the counterfactual path over periods of similar length as the QE2 period (165 daily observation dates). Figure 11 shows these series for the ve- and ten-year maturities along with the average of the counterfactual errors during the QE2 program, indicated with solid gray horizontal lines. We note that it is unprecedented to have a sustained dierence of this magnitude simultaneously at the veand ten-year maturities. This supports the conclusion that the QE2 TIPS purchases pushed the liquidity premium measure to levels well below where they would otherwise have been. 5.3.1 Autoregressive Counterfactual Analysis

As is evident from Figure 11, the residuals from the regressions used in the counterfactual analysis above are serially correlated. A simple Durbin-Watson test gives values of 0.25 and 0.12 at the ve- and ten-year maturity, respectively, which indicates that the positive serial 19

15

10

Average fitted error in basis points

Average fitted error in basis points QE2 average counterfactual error

10

10

10

15

QE2 average counterfactual error 15

15 2005

2006

2007

2008

2009

2010

2011

2005

2006

2007

2008

2009

2010

2011

(a) Five-year maturity.

(b) Ten-year maturity.

Figure 11: Moving Average of Fitted Errors.

Illustration of the moving average of tted errors over periods containing 165 observation dates from the benchmark regression with data ending on November 2, 2010. The shown series cover the period from September 21, 2005, to November 2, 2010, a total of 1,275 observations. The average of the counterfactual errors over the QE2 period from November 3, 2010, to June 30, 2011, is shown with a solid grey line.

correlation is statistically signicant. To address this problem, we include the lagged value of our liquidity premium measure in the regressions, i.e., we use an AR(1) specication. Also, we eliminate the constant term as there is no drift in the liquidity premium series. Thus, we run regressions of the following type LPt ( ) = LPt1 ( ) + T Xt + t , where LPt ( ) is our TIPS and ination swap liquidity premium measure at the -year maturity and Xt represents the exogenous explanatory variables. As in the previous section, we estimate the regressions on the sample from January 5, 2005, to November 2, 2010, which delivers the estimated coecients and reported in Table 4 that describe the statistical relationship before the introduction of QE2. Given the autoregressive specication, the counterfactual analysis is performed in a slightly dierent way as explained in the following. Based on the historical dynamic relationship implied by the estimated coecients in Table 4, we analyze whether the shocks to the liquidity premium measure during QE2 were statistically signicantly more negative than in the preQE2 period. If so, it would suggest that the QE2 TIPS purchases exerted downward pressure on our liquidity premium measure.

20

Explanatory Variables AR(1) coecient VIX O-the-Run Spread AAA Credit Spread IS Bid-Ask Spread TIPS Trading Volume Adjusted R2

Regression 1 5-year 10-year 0.92 (94.38) 0.16 (7.48) 0.95 (130.27) 0.06 (5.84)

Regression 2 5-year 10-year 0.92 (93.83) 0.17 (7.66) -0.07 (-1.60) 0.95 (128.10) 0.04 (2.55) 0.03 (1.64)

Regression 3 5-year 10-year 0.91 (87.18) 0.15 (6.52) -0.07 (-1.64) 0.02 (2.91) 0.95 (127.91) 0.04 (2.15) 0.03 (1.55) 0.00 (0.30)

Regression 4 5-year 10-year 0.91 (81.33) 0.16 (5.60) -0.11 (-2.29) 0.02 (2.81) 0.04 (0.77) -0.09 (-1.62) 0.99 0.94 (111.49) 0.02 (0.92) 0.04 (2.09) 0.00 (0.82) 0.11 (1.64) -0.05 (-0.73) 0.99

0.99

0.99

0.99

0.99

0.99

0.99

Table 4: Regression Results for Pre-QE2 Period with AR(1)-Specication.

The table reports the results of regressions with the TIPS and ination swap liquidity premium measure at the ve- and ten-year horizons as the dependent variables and an AR(1)-term and ve measures of market functioning as explanatory variables. T-statistics are reported in parentheses. Asterisks * and ** indicate signicance at the 5 percent and 1 percent levels, respectively. The data are daily covering the period from January 5, 2005, to November 2, 2010, a total of 1,438 observations.

Focusing on the benchmark regression 4 in Table 4, we calculate realized residuals relative to the counterfactual prediction for the period from November 3, 2010, to June 30, 2011, using
T R t = LPt ( ) LPt1 ( ) + Xt .

(1)

Since the residuals from the regressions in Table 4 have fatter tails than the normal distribution (mainly due to the nancial crisis), we use a Wilcoxon test of the hypothesis that the mean of the realized residuals in equation (1) is identical to the mean of the residuals in the pre-QE2 regression with the alternative being a lower mean of the realized residuals in light of our previous results. At the ve-year maturity, the Wilcoxon test is -1.11 with a p-value of 0.00002, while at the ten-year maturity the test is -0.57 with a p-value of 0.00579. Thus, at both maturities, the results indicate that the shocks to our liquidity premium measure experienced during the QE2 program were signicantly more negative than what would have been predicted based on the historical dynamic relationships. Therefore, consistent with our previous results, we conclude that the TIPS purchases included in the QE2 program reduced the frictions to trading in the TIPS and ination swap markets as captured through our measure of the sum of their respective liquidity premiums.

5.4

Local Supply Eects in the TIPS Market

In this section, we attempt to estimate any direct eects on TIPS prices from the QE2 TIPS purchases by replicating the approach of DK. 21

QE2 Program 4

QE2 Program

Rate in percent

Rate in percent Tenyear yield Fiveyear yield 1 0

Tenyear yield Fiveyear yield

0 2010

2011

2012

2010

2011

2012

(a) Treasury yields.

(b) TIPS yields.

Figure 12: Treasury and TIPS Yields.

Panel (a) illustrates the ve- and ten-year Treasury yields from the G urkaynak et al. (2007) database over the 2010-2011 period. Panel (b) illustrates the ve- and ten-year TIPS yields from the G urkaynak et al. (2010) database over the same period.

Assuming the purchased securities are held for a considerable period of time, QE purchases are eectively equivalent to a reduction in the available stock of the targeted securities. The empirical question is whether uctuations in the supply of government debt should aect yields. Under the expectations hypothesis and in standard term structure models, such supply eects are ruled out. However, models with imperfect asset substitutability or preferred-habitat investors allow for local supply eects on bond yields (see DK for a detailed discussion). Still, as is evident from Figure 12, which shows the changes in the ve- and ten-year Treasury and TIPS yields around the time of the QE2 program, the naked eye is a poor guide for detecting such supply eects as both nominal and real yields increased on net during the QE2 program, but the latter less than the former causing BEI to widen as well. Thus, again, a statistical model is needed to tease out any eects from the asset purchases against this backdrop of generally rising yields. By using security-level data one might hope to be able to identify local supply eects and how they vary across securities with dierent maturities and liquidity characteristics. To do so, we replicate the approach of DK as briey summarized in the following.16 However, we note up front that, unlike the analysis so far, the key element in their approach is to control appropriately for changes in expectations about monetary policy and other economic fundamentals that may aect TIPS prices independent of QE2. Below we will discuss the complications this can bring.
16

All details are provided in Appendix B.

22

Purchases Own Near substitutes

(maturity w/in 2 years of own)

All TIPS -0.023 (-0.83) -0.068 (-1.470) 0.008 (0.560) 427 30 0.733

Far substitutes
(maturity more than 2 years from own)

<10 years to maturity 0.080 (0.950) -0.068 (-0.910) 0.001 (0.030) 284 20 0.762

> 10 years to maturity -0.035 (-1.990) -0.036 (-1.100) 0.004 (0.460) 143 10 0.953

# Obs. # CUSIPs Adjusted R2 Table 5: Flow Eects on Day of Purchase.

The table reports the results of regressions of the ow eects from the QE2 TIPS purchases as described in the text. The rst column reports the results of using all available TIPS with more than two years to maturity, while the following two columns report the result of splitting that sample into one subsample with TIPS with less than ten years to maturity, and one subsample with TIPS with more than ten years to maturity. T-statistics are reported in parentheses. Asterisks * and ** indicate signicance at the 5 percent and 1 percent levels, respectively.

To begin, we follow DK and conduct the regressions in price changes. Second, we drop all TIPS with less than two years remaining to maturity at the beginning of the QE2 program because TIPS near maturity have rather erratic price behavior due to the seasonality and general unpredictability of shocks to the headline consumer price index.17 Third, unlike DK, we only have three maturity buckets related to each security, namely (1) the security itself, (2) the near substitutes with maturities within two years of that of the security, and (3) the far substitutes whose maturities are more than two years from that of the security. Next, we run regressions of the daily percentage price change of each TIPS security n, denoted Rn (t), on a set of variables:
n n n (t) + 1 q1 (t) + 2 q2 (t) + (t) + n + n (t), Rn (t) = 0 q0

(2)

n (t) represents the normalized amount purchased of security n itself, q n (t) is the where q0 1 n (t) is the normalized normalized amount purchased of near substitutes for security n, while q2

amount purchased of far substitutes for security n. Thus, the corresponding coecients can be interpreted as elasticities where 0 is security ns price elasticity to own purchases, 1 is its price elasticity to purchases of near substitutes, and 2 is its price elasticity to purchases of far substitutes. Finally, (t) and n represent time and security xed eects, respectively. Table 5 reports the regression results for the full sample using all available TIPS with
For similar reasons, TIPS with less than two years to maturity are discarded in the construction of the G urkaynak et al. (2010) TIPS yield curve.
17

23

more than two years to maturity as well as the results from the two subsamples with TIPS with less/more than ten years to maturity.18 Overall, the results are surprising in light of our previous results. Most of the coecients of the purchase elasticities do not even have the right sign, and none of them are statistically signicant at conventional levels. In short, it is hard to detect any local supply eects in TIPS prices directly. Various explanations could account for this outcome. First, as emphasized by DK, according to the theory of local supply eects in bond markets (see Vayanos and Vila 2009), they are more likely to matter when liquidity and market functioning is poor, i.e., when the arbitrageurs who trade away prot opportunities along the yield curve are capital constrained; thus, only taking on the most protable trades, not necessarily all available arbitrages. As noted in Figure 3, our measure of TIPS and ination swap market functioning had reached pre-crisis levels well before the announcement of the QE2 program. Thus, it is indeed possible that market functioning could have been restored and local supply eects would be small for that reason. However, this explanation would contradict our previous results. More likely, we think that there are issues with the specication of the time xed eects represented by (t). This specication provides a poor proxy for changes in the shape of the yield curve on purchase dates. For example, a level shift in the TIPS yield curve will aect the prices of long-maturity TIPS in a very dierent way than the prices of short-maturity TIPS.19 By contrast, the time xed eect imposes an identical price response across all TIPS. In addition, the security xed eects represented by n do not mitigate any of this, as they are constant through time. Furthermore, the bias from this misspecication might be more severe in our case than in the analysis of DK for two reasons. First, our pool of TIPS is smaller and more heterogeneous than their sample of regular Treasuries that is dominated by securities with three to ten years remaining to maturity.20 Second, the limited number of purchase dates in our analysis could matter as well since it allows for less averaging of any errors induced by the misspecied time xed eects. To summarize, we believe there are compelling reasons why we are not able to identify any ow eects on individual TIPS prices from the QE2 TIPS purchases using the approach of DK, despite the clear results we obtain when we analyze the eects on our TIPS and ination swap liquidity measure. The key dierence is that our approach is unaected by changes in expectations about economic fundamentals, whereas the DK approach could be severely biased by them.
We split the sample around the ten-year maturity point as there is a discrete jump in TIPS outstanding with remaining maturity above ten years, as can also be seen in Figure 1(b). 19 Figure 12(b) shows that the TIPS curve did experience several level shifts during the QE2 program. 20 The closer securities are in terms of maturity, the smaller the room for error is from the misspecication of the time xed eects.
18

24

Conclusion

In this paper, we analyze the eects the TIPS purchases included in the Feds QE2 program had on the functioning of the market for TIPS and the related market for ination swaps. To quantify the frictions in the markets for these two types of nancial claims, we use the model-independent measure of the sum of liquidity premiums in TIPS yields and ination swap rates derived in CG. This measure is ideal for our purposes as it is unaected by how the QE2 program and its implementation might have changed investors expectations for economic fundamentals. Our results from both regressions with binary event variables and counterfactual analysis suggest that the TIPS purchases reduced the liquidity premiums for these securities. Specically, the counterfactual analysis indicates that the purchases persistently depressed the liquidity premium measure by an average of 12 to 14 basis points for the duration of the QE2 program from what we would otherwise have expected it to be. In our view, this represents a considerable reduction. Furthermore, and critical to our interpretation, the liquidity premium eects dissipated towards the end of the QE2 TIPS purchases. This leads us to conclude that one benet of QE programs is to improve nancial market functioning by reducing liquidity premiums through a direct purchase eect. However, our results also show the limitation of such purchase eects in that they appear to only be sustained as long as purchases are on-going and expected to continue. In an attempt to identify purchase eects in individual TIPS prices from the QE2 TIPS purchases, we adapted the approach of DK. However, most likely due to misspecication of the time xed aects in their regressions, our analysis did not yield any signicant results. Thus, we leave this question for future research. Finally, another underresearched area is the extent to which the improvement in market functioning from QE asset purchases extends beyond the safest assets such as Treasuries, TIPS, and mortgage-backed securities. In particular, the impact on the functioning of corporate bond markets would be interesting to study because any improvement in the eciency of their pricing would translate into real economic benets as rms would be able to obtain external nancing at lower costs. Again, we leave this important question for future research.

25

Explanatory Variables Constant VIX O-the-Run Spread AAA Credit Spread IS Bid-Ask Spread TIPS Trading Volume Adjusted R2

Regression 1 5-year 10-year -3.47 (-4.43) 2.21 (69.74) 9.29 (12.32) 0.96 (31.45)

Regression 2 5-year 10-year -6.77 (-7.61) 2.39 (60.83) -0.94 (-7.36) 11.59 (15.43) 0.36 (5.90) 0.65 (11.30)

Regression 3 5-year 10-year -5.05 (-5.94) 1.88 (35.12) -0.78 (-6.49) 0.18 (13.24) 11.55 (15.33) 0.38 (5.65) 0.65 (11.27) -0.01 (-0.71)

Regression 4 5-year 10-year -10.31 (-3.55) 1.50 (23.55) -0.96 (-8.29) 0.29 (17.99) 1.53 (11.23) -0.86 (-3.19) 0.82 18.30 6.68) 0.25 (3.80) 0.41 (6.88) 0.11 (6.74) 2.45 (12.02) -3.34 (-10.97) 0.52

0.77

0.41

0.78

0.46

0.80

0.46

Table 6: Baseline Regression Results for Pre-QE2 Period.

The table reports the results of regressions with the TIPS and ination swap liquidity premium measure at the ve- and ten-year horizons as the dependent variables and ve measures of market functioning as explanatory variables. T-statistics are reported in parentheses. Asterisks * and ** indicate signicance at the 5 percent and 1 percent levels, respectively. The data are daily covering the period from January 4, 2005, to November 2, 2010, a total of 1,439 observations.

Appendix A: Regression Results Used in Counterfactual Analysis

In the construction of our counterfactual, we rely on the historical connection between our liquidity premium measure and the ve explanatory variables we use. Table 6 reports the results for the baseline regressions using the pre-QE2 part of our data sample, i.e., the sample from January 4, 2005, to November 2, 2010. The estimated coecients reported under regression 4 in the table are the ones used in the counterfactual analysis in Section 5.3.

Appendix B: Replication of DAmico and King (2013)

In this appendix, we describe our adaptation of DKs analysis of ow eects from QE purchases. First, we introduce notation and dene the fundamental statistical objects, which are as follows: (i ). N is the total number of TIPS in existence during the QE2 program. (ii ). On (t) equals the notional amount of security n outstanding at t, n {1, . . . , N }. (iii ). Qn (t) equals the dollar amount of security n purchased at t, n {1, . . . , N }. (iv ). Rn (t) =
P n (t)P n (t1) P n (t1)

is the daily percentage price change of security n at time t, n {1, . . . , N }.

(v ). T n is the maturity date of security n, n {1, . . . , N }. The second step is to calculate the variables to be used as input in the subsequent regressions. Similar to DK, for each security n, we dene buckets of substitutes, but limit the number to three buckets due to the smaller number of TIPS trading relative to the number of securities in the market for regular Treasury securities. As in DK, the rst bucket is denoted S0 (n) and just contains security n itself. Related to bucket 0 we dene two variables:
n (i ). O0 (t) = On (t) is the notional amount of security n outstanding.

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n (ii ). Qn 0 (t) = Q (t) is the amount of security n purchased at time t.

The second bucket is denoted S1 (n) and contains all securities with maturities within two years of the maturity of security n, i.e., S1 (n) = {m : |T m T n | 2}. Following DK we refer to these securities as the near substitutes for security n. Finally, the third bucket is denoted S2 (n) and contains all securities with a dierence in maturity of more than two years relative to the maturity of security n, i.e., S2 (n) = {m : |T m T n | > 2}. Again, using language similar to DK, we refer to these securities as the far substitutes for security n. Related to the last two buckets, the following variables are dened:
n (i ). Oi (t ) = mSi (n)

Om (t) is the notional amount outstanding of bucket i substitutes for security n at Qm (t) is the amount of bucket i substitutes for security n purchased at time t,

time t, i {1, 2}. (ii ). Qn i (t ) = i {1, 2}. As in DK, we use normalized variables in the regressions:
n (i ). q0 (t ) = Qn 0 (t ) n (t)+O n (t) O0 1 mSi (n)

is the amount of security n purchased at time t relative to the notional amount

outstanding of security n itself and its near substitutes.

n (ii ). qi (t ) = Qn i (t ) n (t)+O n (t) O0 1

is the amount of bucket i substitutes for security n purchased at time t relative to

the notional amount outstanding of security n itself and its near substitutes, i {1, 2}. Finally, similar to DK, we run regressions of the daily percentage price change of each TIPS security on a set of variables:
n n n Rn (t) = 0 q0 (t) + 1 q1 (t) + 2 q2 (t) + (t) + n + n (t),

where 0 is security ns price elasticity to own purchases, 1 is security ns price elasticity to purchases of near substitutes, 2 is security ns price elasticity to purchases of far substitutes, (t) represents time xed eects, and n represents security xed eects.

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