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Liquidity Effects in the Bond Market


  • Boyan Jovanovic

    (University of Chicago, NYU, and NBER)

  • Peter L. Rousseau

    () (Department of Economics, Vanderbilt University and NBER)


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 For reasons we shall discuss in the body of the paper, the amount of securities offered to the public or withdrawn from circulation is not fully predictable.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."

Suggested Citation

  • Boyan Jovanovic & Peter L. Rousseau, 2001. "Liquidity Effects in the Bond Market," Vanderbilt University Department of Economics Working Papers 0117, Vanderbilt University Department of Economics.
  • Handle: RePEc:van:wpaper:0117

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    References listed on IDEAS

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    4. Barsky, Robert B, 1989. "Why Don't the Prices of Stocks and Bonds Move Together?," American Economic Review, American Economic Association, vol. 79(5), pages 1132-1145, December.
    5. W. Braddock Hickman, 1952. "Appendix to "Trends and Cycles in Corporate Bond Financing"," NBER Chapters,in: Trends and Cycles in Corporate Bond Financing, pages 31-37 National Bureau of Economic Research, Inc.
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    8. Milton Friedman & Anna Jacobson Schwartz, 1970. "Monetary Statistics of the United States: Estimates, Sources, Methods," NBER Books, National Bureau of Economic Research, Inc, number frie70-1, January.
    9. Evans, Charles L. & Marshall, David A., 1998. "Monetary policy and the term structure of nominal interest rates: Evidence and theory," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 49(1), pages 53-111, December.
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    11. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, vol. 50(2), pages 237-264, April.
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    Cited by:

    1. Ellen R. McGrattan & Edward C. Prescott, 2004. "The 1929 Stock Market: Irving Fisher Was Right," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 45(4), pages 991-1009, November.
    2. Lundblad, Christian, 2007. "The risk return tradeoff in the long run: 1836-2003," Journal of Financial Economics, Elsevier, vol. 85(1), pages 123-150, July.
    3. Arvind Krishnamurthy & Annette Vissing-Jorgensen, 2007. "The Demand for Treasury Debt," NBER Working Papers 12881, National Bureau of Economic Research, Inc.
    4. Ellen R. McGrattan & Edward C. Prescott, 2001. "The Stock Market Crash of 1929: Irving Fisher Was Right!," NBER Working Papers 8622, National Bureau of Economic Research, Inc.

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    JEL classification:

    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy


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