An updated Federal Reserve paper suggests that there has long been a link between the net supply of government securities and term premia on Treasury yields. A 1%-point reduction in the ratio of Treasuries or MBS (10-year equivalent) to GDP supposedly reduced the 10-year term premium by 10 basis points. A one-year shortening of the average effective duration would lower the ten-year Treasury yield by about 7 basis points. Based on these estimates, the 2008-2011 large scale asset purchase and maturity extension programs of the Federal Reserve could have reduced the 10-year term premium by a total of 150 basis points.
Term Structure Modeling with Supply Factors and the Federal Reserve’s Large Scale Asset Purchase Programs.
Canlin Li and Min Wei, Federal Reserve Board, Finance and Economic Discussion Series (2014-07)
The below are excerpts from the paper. Emphasis and cursive text has been added.
The estimated relation between asset purchases and term premia
“[Simple regression analysis over the sample period of March 1994 to July 2007 finds] preliminary evidence suggesting there exists a link between the supply of government securities and Treasury term premiums…The difference between total [Treasury] debt outstanding and SOMA [Federal Reserve’s System of Open Market Account] holdings gives us the par amount held by private investors for each security…term premiums are significantly and positively related to the supply variables after controlling for other economic factors.”
“We also use… [an arbitrage-free term structure model] to evaluate the three LSAP [Large Scale Asset Purchase] programs announced by the Federal Reserve [from 2008 to 2011]. Past empirical analysis of the LSAPs is typically based on either event studies or time series regressions of Treasury yields or term premiums on supply variables…Results based on event studies are known to be sensitive to the selection of event windows. Time series regressions used in these studies, on the other hand, are likely susceptible to small-sample bias… and endogeneity problems, as changes in Treasury supply are likely correlated with other factors driving the yield curve.”
“We motivate our model by assuming the existence of two types of private participants in the Treasury market: preferred-habitat investors, who hold only a particular maturity segment of the Treasury yield curve, and risk averse arbitrageurs, who trade to take advantage of arbitrage opportunities…We estimate the model using monthly data on Treasury yields and private holdings of Treasury and Agency MBS from March 1994 to July 2007…this model suggests that a one-percentage-point decline in the Treasury ten-year equivalent to-GDP ratio or the MBS par-to-GDP ratio would reduce the ten year Treasury yield by about 10 basis points, while a one-year shortening of the average effective duration of private MBS holdings would lower the ten-year Treasury yield by about 7 basis points.”
“The Federal Reserve’s various asset purchase programs provide natural experiments for assessing the effects of exogenous shocks to the supply of Treasury securities and their close substitutes on Treasury yields [See quick summary of the three first asset purchase programs in an annex below]… We use the estimated factor loading…to estimate the term premium effects of such supply shocks… We estimate that the LSAP1 program lowered the ten-year Treasury yield by about 100 basis points, the five-year yield by about 65 basis points, and the two-year yield by about 25 basis points in the near term. By comparison, the other two programs, the LSAP2 program and the MEP, are both estimated to have lowered the ten-year Treasury yield by about 25 basis points and the five-year yield by 10 to 15 basis points, but have almost no effect on the two-year Treasury yield.”
“The term premium effect of a program depends on both the purchase amount and investors’ expectations about the timing and pace of future exit sales. Similarly, the term premium effect of a program can change over time depending on changing investor expectations of the timing and pace of future exit sales…The further away and the slower the future exit sales, the bigger the term premium effect, since the offsetting effects from those future sales will be smaller in these cases.”
Annex: The Feds first three asset purchase programs
“On November 25, 2008, the FOMC announced the LSAP1 consisting of USD100 billion of purchases of agency debt and up to USD500 billion of purchases of agency MBS. In March 2009, the FOMC expanded the LSAP1 program to include an additional USD750 billion purchase of agency securities and USD300 billion purchase of longer-term Treasury securities. The program was completed in March 2010, with a total purchase of USD1.25 trillion of agency MBS, about USD170 billion of agency debt, and USD300 billion of Treasury securities [giving a total of USD1.75 trillion or roughly 12% of 2009 GDP]”
“On November 3, 2010, the FOMC announced the LSAP2, under which it would purchase USD600 billion of longer-term Treasury securities [4% of 2010 GDP] over an 8-month period through June 2011. LSAP2 was completed as announced, with the bulk of purchases concentrated in nominal Treasury securities with 2- to 10-year maturities.”
“On September 21, 2011, the FOMC announced the MEP [Maturity Extension Program], under which the FOMC will purchase, by the end of June 2012, USD400 billion of Treasury securities [2.6% of 2011 GDP] with remaining maturities of 6 to 30 years while simultaneously selling an equal amount of Treasuries with remaining maturities of 3 years or less.”