Hostname: page-component-78c5997874-s2hrs Total loading time: 0 Render date: 2024-11-03T01:25:24.611Z Has data issue: false hasContentIssue false
  • English
  • Français

Government Intervention and Strategic Trading in the U.S. Treasury Market

Published online by Cambridge University Press:  18 December 2018

Paolo Pasquariello ,
Jennifer Roush  and
Clara Vega
Get access Rights & Permissions [Opens in a new window]

Abstract

We study the impact of permanent open market operations (POMOs) by the Federal Reserve on U.S. Treasury market liquidity. Using a parsimonious model of speculative trading, we conjecture that i) this form of government intervention improves market liquidity, contrary to conclusions drawn by existing literature; and ii) the extent of this improvement depends on the market’s information environment. Evidence from a novel sample of Federal Reserve POMOs during the 2000s indicates that bid–ask spreads of on-the-run Treasury securities decline when POMOs are executed, by an amount increasing in proxies for information heterogeneity among speculators, fundamental volatility, and POMO policy uncertainty, consistent with our model.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 55 , Issue 1 , February 2020 , pp. 117 - 157
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2018 

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

Footnotes

1

We thank Michael Gulick for outstanding research assistance, and an anonymous referee, Gara Afonso, Hendrik Bessembinder (the editor), Sugato Bhattacharyya, Tarun Chordia, Robert Engle, Andreas Fischer, Michael Fleming, Thierry Foucault, Larry Harris, Kentaro Iwatsubo, Collin Jones, Andrew Karolyi, Marc Lipson, Anna Obizhaeva, Maureen O’Hara, Amiyatosh Purnanandam, Marti Subrahmanyam, Rufei Zhu, and seminar participants at the Banque de France, University of Warwick, Swiss National Bank, University College London, the 2011 EFA meetings, the 2011 NBER Market Microstructure meetings, the 2014 AFA meetings, Washington State University, and the 2014 International Conference on Sovereign Bond Markets for comments. The views in this article are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or of any other person associated with the Federal Reserve System. All errors are ours.

References

Acharya, V., and Richardson, M. (eds.), Restoring Financial Stability: How to Repair a Failed System—An Independent View from New York University Stern School of Business, John Wiley & Sons (2009).Google Scholar
Afonso, G.; Kovner, A.; and Schoar, A.. “Stressed, Not Frozen: The Federal Funds Market in the Financial Crisis.” Journal of Finance, 66 (2011), 1109–1139.Google Scholar
Akhtar, M.“Understanding Open Market Operations.” Federal Reserve Bank of New York, Public Information Department (1997).Google Scholar
Andersen, T., and Bollerslev, T.. “Deutsche Mark-Dollar Volatility: Intraday Activity Patterns, Macroeconomic Announcements, and Longer Run Dependencies.” Journal of Finance, 53 (1998), 219–265.Google Scholar
Andersen, T.; Bollerslev, T.; Diebold, F.; and Vega, C.. “Micro Effects of Macro Announcements: Real-Time Price Discovery in Foreign Exchange.” American Economic Review, 93 (2003), 38–62.Google Scholar
Andersen, T.; Bollerslev, T.; Diebold, F.; and Vega, C.. “Real-Time Price Discovery in Stock, Bond, and Foreign Exchange Markets.” Journal of International Economics, 73 (2007), 251–277.Google Scholar
Bernanke, B., and Kuttner, K.. “What Explains the Stock Market’s Reaction to Federal Reserve Policy?” Journal of Finance, 60 (2005), 1221–1257.Google Scholar
Bhattacharya, U., and Weller, P.. “The Advantage of Hiding One’s Hand: Speculation and Central Bank Intervention in the Foreign Exchange Market.” Journal of Monetary Economics, 39 (1997), 251–277.Google Scholar
Bossaerts, P., and Hillion, P.. “Market Microstructure Effects of Government Intervention in the Foreign Exchange Market.” Review of Financial Studies, 4 (1991), 513–541.Google Scholar
Brandt, M., and Kavajecz, K.. “Price Discovery in the U.S. Treasury Market: The Impact of Order Flow and Liquidity on the Yield Curve.” Journal of Finance, 59 (2004), 2623–2654.Google Scholar
Brenner, M.; Pasquariello, P.; and Subrahmanyam, M.. “On the Volatility and Comovement of U.S. Financial Markets around Macroeconomic News Announcements.” Journal of Financial and Quantitative Analysis, 44 (2009), 1265–1289.Google Scholar
Caballé, J., and Krishnan, M.. “Imperfect Competition in a Multi-Security Market with Risk Neutrality.” Econometrica, 62 (1994), 695–704.Google Scholar
Chari, A.“Heterogeneous Market-Making in Foreign Exchange Markets: Evidence from Individual Bank Responses to Central Bank Interventions.” Journal of Money, Credit, and Banking, 39 (2007), 1131–1161.Google Scholar
Chordia, T.; Hu, J.; Subrahmanyam, A.; and Tong, Q.. “Order Flow Volatility and Equity Costs of Capital.” Management Science, 65 (2019), 1520–1551.Google Scholar
Chordia, T.; Sarkar, A.; and Subrahmanyam, A.. “An Empirical Analysis of Stock and Bond Market Liquidity.” Review of Financial Studies, 18 (2005), 85–129.Google Scholar
Chordia, T., and Subrahmanyam, A.. “Order Imbalance and Individual Stock Returns: Theory and Evidence.” Journal of Financial Economics, 72 (2004), 485–518.Google Scholar
Christensen, J., and Rudebusch, G.. “The Response of Interest Rates to U.S. and U.K. Quantitative Easing.” Economic Journal, 122 (2012), 385–414.Google Scholar
Cieslak, A.; Morse, A.; and Vissing-Jorgensen, A.. “Stock Returns over the FOMC Cycle.” Working Paper, University of California-Berkeley (2016).Google Scholar
Cohen, B.“Monetary Policy Procedures and Volatility Transmission along the Yield Curve.” Working Paper, Bank for International Settlements (1999).Google Scholar
Croushore, D.“Introducing: The Survey of Professional Forecasters.” Business Review, Federal Reserve Bank of Philadelphia (1993), 3–15.Google Scholar
D’Amico, S.; English, W.; Lopez-Salido, D.; and Nelson, E.. “The Federal Reserve’s Large-Scale Asset Purchase Programs: Rationale and Effects.” Economic Journal, 122 (2012), 415–446.Google Scholar
D’Amico, S., and King, T.. “Flow and Stock Effects of Large-Scale Treasury Purchases: Evidence on the Importance of Local Supply.” Journal of Financial Economics, 108 (2013), 425–448.Google Scholar
Diether, K.; Malloy, C.; and Scherbina, A.. “Differences of Opinion and the Cross Section of Stock Returns.” Journal of Finance, 57 (2002), 2113–2141.Google Scholar
Dominguez, K.“The Market Microstructure of Central Bank Intervention.” Journal of International Economics, 59 (2003), 25–45.Google Scholar
Dominguez, K.“When Do Central Bank Interventions Influence Intra-Daily and Longer-Term Exchange Rate Movements?” Journal of International Money and Finance, 25 (2006), 1051–1071.Google Scholar
Edwards, C.“Open Market Operations in the 1990s.” Federal Reserve Bulletin, 83 (1997), 859–874.Google Scholar
Eser, F., and Schwaab, B.. “Evaluating the Impact of Unconventional Monetary Policy Measures: Empirical Evidence from the ECB’s Securities Markets Programme.” Journal of Financial Economics, 119 (2016), 147–167.Google Scholar
Evans, M., and Lyons, R.. “Order Flow and Exchange Rate Dynamics.” Journal of Political Economy, 110 (2002), 170–180.Google Scholar
Evans, M., and Lyons, R.. “Are Different-Currency Assets Imperfect Substitutes?” In Exchange Rate Economics: Where Do We Stand?, De Grauwe, P., ed. MIT Press (2005), 1–34.Google Scholar
Fabozzi, F., and Fleming, M.. “U.S. Treasury and Agency Securities.” In The Handbook of Fixed Income Securities, Fabozzi, F., ed. New York, NY: McGraw Hill (2004), 229–250.Google Scholar
Federal Reserve Bank of New York (FRBNY). Domestic Open Market Operations during 2004. Federal Reserve System Publication (2005).Google Scholar
Federal Reserve Bank of New York (FRBNY). Domestic Open Market Operations during 2007. Federal Reserve System Publication (2008).Google Scholar
Federal Reserve Board of Governors (FRBG). The Federal Reserve System: Purposes and Functions. Federal Reserve System Publication (2005).Google Scholar
Fleming, M.“The Round-the-Clock Market of U.S. Treasury Securities.” Economic Policy Review, Federal Reserve Bank of New York, 3 (1997), 9–32.Google Scholar
Fleming, M.“Measuring Treasury Market Liquidity.” Economic Policy Review, Federal Reserve Bank of New York, 9 (2003) 83–108.Google Scholar
Fleming, M.; Mizrach, B.; and Nguyen, G.. “The Microstructure of a U.S. Treasury ECN: The BrokerTec Platform.” Journal of Financial Markets, 40 (2018), 2–22.Google Scholar
Foster, F., and Viswanathan, S.. “Strategic Trading When Agents Forecast the Forecasts of Others.” Journal of Finance, 51 (1996), 1437–1478.Google Scholar
Furfine, C.“The Microstructure of the Federal Funds Market.” Financial Markets, Institutions & Instruments, 8 (1999), 24–44.Google Scholar
Gagnon, J.; Raskin, M.; Remache, J.; and Sack, B.. “The Financial Market Effects of the Federal Reserve’s Large-Scale Asset Purchases.” International Journal of Central Banking, 7 (2011), 3–43.Google Scholar
George, T.; Kaul, G.; and Nimalendran, M.. “Estimation of the Bid–Ask Spread and Its Components: A New Approach.” Review of Financial Studies, 4 (1991), 623–656.Google Scholar
Gilbert, T.; Scotti, C.; Strasser, G.; and Vega, C.. “Is the Intrinsic Value of a Macroeconomic News Announcement Related to Its Asset Price Impact?” Journal of Monetary Economics, 92 (2017), 78–95.Google Scholar
Goldreich, D.; Hanke, B.; and Nath, P.. “The Price of Future Liquidity: Time-Varying Liquidity in the U.S. Treasury Market.” Review of Finance, 9 (2005), 1–32.Google Scholar
Green, C.“Economic News and the Impact of Trading on Bond Prices.” Journal of Finance, 59 (2004), 1201–1233.Google Scholar
Greene, W. Econometric Analysis. Upper Saddle River, NJ: Prentice Hall (1997).Google Scholar
Greenwood, R., and Vayanos, D.. “Price Pressure in the Government Bond Market.” American Economic Review: Papers and Proceedings, 100 (2010), 585–590.Google Scholar
Hamilton, J., and Wu, C.. “The Effectiveness of Alternative Monetary Policy Tools in a Zero Lower Bound Environment.” Journal of Money, Credit, and Banking, 44 (2011), 3–46.Google Scholar
Harvey, C., and Huang, R.. “The Impact of the Federal Reserve Bank’s Open Market Operations.” Journal of Financial Markets, 5 (2002), 223–257.Google Scholar
Hasbrouck, J.“Measuring the Information Content of Stock Trades.” Journal of Finance, 46 (1991), 179–207.Google Scholar
Hasbrouck, J. Empirical Market Microstructure. Oxford, UK: Oxford University Press (2007).Google Scholar
Hu, X.; Pan, J.; and Wang, J.. “Noise as Information for Illiquidity.” Journal of Finance, 68 (2013), 2223–2772.Google Scholar
Inoue, H.“The Effects of Open Market Operations on the Price Discovery Process in the Japanese Government Securities Market: An Empirical Study.” Working Paper, Bank of Japan (1999).Google Scholar
Jenkins, M., and Traub, J.. “A Three-Stage Variables-Shift Iteration for Polynomial Zeros and Its Relation to Generalized Rayleigh Iteration.” Numerishe Mathematik, 14 (1970a), 252–263.Google Scholar
Jenkins, M., and Traub, J.. “A Three-Stage Algorithm for Real Polynomials Using Quadratic Iteration.” SIAM Journal of Numerical Analysis, 7 (1970b), 545–566.Google Scholar
Jones, C.; Kaul, G.; and Lipson, M.. “Transactions, Volume, and Volatility.” Review of Financial Studies, 7 (1994), 631–651.Google Scholar
Kitsul, Y.“Large-Scale Asset Purchases and Liquidity of Treasury Securities.” Working Paper, Federal Reserve Board of Governors (2013).Google Scholar
Krishnamurthy, A.“The Bond/Old-Bond Spread.” Journal of Financial Economics, 66 (2002), 463–506.Google Scholar
Krishnamurthy, A.; Nagel, S.; and Vissing-Jorgensen, A.. “ECB Policies Involving Government Bond Purchases: Impact and Channel.” Review of Finance, 22 (2018), 1–44.Google Scholar
Krishnamurthy, A., and Vissing-Jorgensen, A.. “The Effects of Quantitative Easing on Interest Rates.” Brookings Papers on Economic Activity, (2011), 215–287.Google Scholar
Krishnamurthy, A., and Vissing-Jorgensen, A.. “The Aggregate Demand for Treasury Debt.” Journal of Political Economy, 120 (2012), 233–267.Google Scholar
Kumar, P., and Seppi, D.. “Futures Manipulation with ‘Cash Settlement’.” Journal of Finance, 47 (1992), 1485–1502.Google Scholar
Kyle, A.“Continuous Auctions and Insider Trading.” Econometrica, 53 (1985), 1315–1335.Google Scholar
Li, H.; Wang, J.; Wu, C.; and He, Y.. “Are Liquidity and Information Risks Priced in the Treasury Bond Market?” Journal of Finance, 64 (2009), 467–503.Google Scholar
Lyons, R. The Microstructure Approach to Exchange Rates. Cambridge, MA: MIT Press (2001).Google Scholar
Mizrach, B., and Neely, C.. “The Transition to Electronic Communications Networks in the Secondary Treasury Market.” Federal Reserve Bank of St. Louis Review, 88 (2006), 527–541.Google Scholar
Mizrach, B., and Neely, C.. “The Microstructure of the U.S. Treasury Market.” In Encyclopedia of Complexity and Systems Science, Meyers, R., ed. Springer-Verlag (2009), 9565–9577.Google Scholar
Naranjo, A., and Nimalendran, M.. “Government Intervention and Adverse Selection Costs in Foreign Exchange Markets.” Review of Financial Studies, 13 (2000), 453–477.Google Scholar
Neely, C.“Identifying the Effects of U.S. Intervention on the Levels of Exchange Rates.” Reserve Bank of St. Louis Working Paper No. 2005-031C (2005).Google Scholar
Novshek, W.“Finding All n-Firm Cournot Equilibria.” International Economic Review, 25 (1984), 61–70.Google Scholar
O’Hara, M. Market Microstructure Theory. Cambridge, MA: Blackwell (1995).Google Scholar
Pasquariello, P.“Imperfect Competition, Information Heterogeneity, and Financial Contagion.” Review of Financial Studies, 20 (2007a), 391–426.Google Scholar
Pasquariello, P.“Informative Trading or Just Costly Noise? An Analysis of Central Bank Interventions.” Journal of Financial Markets, 10 (2007b), 107–143.Google Scholar
Pasquariello, P.“Central Bank Intervention and the Intraday Process of Price Formation in the Currency Markets.” Journal of International Money and Finance, 29 (2010), 1045–1061.Google Scholar
Pasquariello, P.“Government Intervention and Arbitrage.” Review of Financial Studies, 31 (2018), 3344–3408.Google Scholar
Pasquariello, P., and Vega, C.. “Informed and Strategic Order Flow in the Bond Markets.” Review of Financial Studies, 20 (2007), 1975–2019.Google Scholar
Pasquariello, P., and Vega, C.. “The On-the-Run Liquidity Phenomenon.” Journal of Financial Economics, 92 (2009), 1–24.Google Scholar
Pasquariello, P., and Vega, C.. “Strategic Cross-Trading in the U.S. Stock Market.” Review of Finance, 9 (2015), 229–282.Google Scholar
Payne, R., and Vitale, P.. “A Transaction Level Study of the Effects of Central Bank Intervention on Exchange Rates.” Journal of International Economics, 61 (2003), 331–352.Google Scholar
Sarno, L., and Taylor, M.. “Official Intervention in the Foreign Exchange Market: Is It Effective, and If So, How Does It Work?” Journal of Economic Literature, 39 (2001), 839–868.Google Scholar
Sokolov, V.“The Impact of Open Market Operations on the Government Bond Market: Microstructure Evidence.” Working Paper, Higher School of Economics (2009).Google Scholar
Song, Z., and Zhu, H.. “Quantitative Easing Auctions of Treasury Bonds.” Journal of Financial Economics, 128 (2018), 103–124.Google Scholar
Stein, J.“Cheap Talk and the Fed: A Theory of Imprecise Policy Announcements.” American Economic Review, 79 (1989), 32–42.Google Scholar
Stoll, H.“Inferring the Components of the Bid-Ask Spread: Theory and Empirical Tests.” Journal of Finance, 44 (1989), 115–134.Google Scholar
Strebulaev, I.“Liquidity and Asset Pricing: Evidence from the U.S. Treasury Securities Market.” Working Paper, London Business School (2002).Google Scholar
Vayanos, D., and Vila, J.. “A Preferred-Habitat Model of the Term Structure of Interest Rates.” NBER Working Paper No. 15487 (2009).Google Scholar
Vitale, P.“Sterilised Central Bank Intervention in the Foreign Exchange Market.” Journal of International Economics, 49 (1999), 245–267.Google Scholar
Yu, J.“Disagreement and Return Predictability of Stock Portfolios.” Journal of Financial Economics, 99 (2011), 162–183.Google Scholar
Supplementary material: File

Pasquariello et al. supplementary material

Pasquariello et al. supplementary material
Download Pasquariello et al. supplementary material(File)
File 178 KB