The Market for Commonwealth Government Securities

This study examines the demand for Commonwealth government securities in Australia from 1961(1) to 1978(2). Given that a variety of regulations and constraints compel many financial institutions to hold certain levels of government securities, the main emphasis of the analysis is on explaining movements in discretionary holdings. Equations are estimated from quarterly data using ordinary least squares for the following financial groups: a) all non-bank private groups; b) authorised dealers in the short term money market; c) life insurance offices; d) other financial institutions; e) household and corporate sector groups; and f) major trading banks. This study takes a particular interest in the way the demand for government securities has been influenced by expectations about future interest rates. We note the difficulties previous studies have encountered in this area and introduce two new measures of interest rate expectations. For the first measure we establish that interest rate movements have been non-random over the sample period and use a Box-Jenkins model to estimate optimal extrapolative expectations from past interest rate data. The second measure assumes perfect foresight. Both measures are constructed so that the expected yield incorporates changes in the market value of securities implied by interest rate changes. The first measure, based on past interest rates does not add explanatory power to our estimates of the demand for securities. In contrast, the measure assuming perfect foresight is found to markedly improve explanations of the demand for government securities for most groups in the market. The disparate results for the two measures reinforce the widely held belief that expectations are formed efficiently, and in a manner sufficiently complex that representation by simple extrapolative mechanisms must be regarded as inadequate. Perfect foresight is unquestionably too strong an assumption, but it probably lies much closer to reality than the extrapolative model. The success of the perfect foresight assumption, while not of itself offering much information on the process of expectations formation, does provide a basis for interpreting the operation of the government securities market. In our judgement the “foresight” of investors in government securities may be significantly attributed to the way authorities will occasionally tolerate quantity adjustments in the government securities market to postpone interest rate adjustments.