Liquidity Effects in the Bond Market

U.S. Treasury securities are nominal assets that are subject to two sources of risk: inflation risk, and bond-supply risk. Inflation risk is well-known, but supply risk has received little attention. For reasons we shall discuss in the body of the paper, the amount of securities offered to the public or withdrawn from circulation is not fully predictable. Because participation in these markets requires some liquidity, when the supply of T-bills fluctuates, participants in the market must either accept the changes in the rates of interest, or else end up with lower rate of return assets as substitutes. Our study begins with a look at monthly data over the past eighty years of Fed history. We find that supply risk has added about a 13 basis-point risk to the real rate of return on three-month T-bills over the postwar period, which is down from an average of about 36 basis-points over the 1920-46 period. The effect\ of inflation risk on the T-bill rate, on the other hand, has declined from nearly five and a half percentage points before the war to only one percent over the past 20 years as Fed policy has rendered the price level more and more predictable. Next, we study how the stock market responds to shocks in the supply of Treasury securities. An increase in the supply of T-bills should lower their price and raise their rate of return. One may conjecture, then, that an increase in the supply of T-bills should also lower the price of stocks (a substitute asset) and raise \textit{their} rate of return. In one dimension, this conjecture turns out to be correct: Over the 1920-99 period, stock returns and T-bill rates are both positively related to surprises in the growth of T-bills, although the correlation with stock returns is very small. The conjecture is not entirely correct, though, because stock returns are negatively correlated with the T-bill rate. This suggests that the bond market and the stock market are segmented. Finally, we briefly examine the long-term trends in U.S. Treasury financing. The share of bonds in the aggregate security portfolio rises sharply until about the end of the Second World War, and then it declines fairly steadily. These trends do not seem to be related to the overall levels of interest rates and asset yields in the various periods. At monthly frequencies, however, supply risk in the bond market continues to matter in spite of these shifts in the relative importance of bonds. To sum up: We find that liquidity effects of bond injections are substantial, and that they have been with us for as long as we have the data to measure them. When measured in this way, the liquidity effect seems larger than what one can infer when one measures liquidity by the supply of money -- whether money defined as nonborrowed reserves or more broadly. The Fed seems to be trying to keep the risk associated with these injections to a minimum, but is not able to push it to zero because the gradual paydown of the Federal debt has necessitated a less accommodative stance with regard to unexpectedly large rollover demands for Treasury securities among foreign financial institutions and international monetary authorities. Further, so long as the Fed uses the secondary market for Treasury securities as its primary means of conducting open market operations, shocks to the supply of these securities that are available to the public will persist. This suggests that as the supply of outstanding Treasury securities falls, a policy that seeks to minimize surprises to this supply by increasing the use of other debt instruments for open market operations will help Treasury securities to maintain their desirable feature of true "risklessness."