Let’s Twist Again: A High-Frequency Event-Study Analysis of Operation Twist

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Lets Twist Again: A High-Frequency Event-Study Analysis of Operation Twist and Its Implications for QE2. Eric T. Swanson Federal Reserve Bank of San Francisco. Stanford Macro Seminar April 4, 2011. - PowerPoint PPT Presentation

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Lets Twist Again: A High-FrequencyEvent-Study Analysis of Operation Twistand Its Implications for QE2Stanford Macro SeminarApril 4, 2011

Eric T. SwansonFederal Reserve Bank of San FranciscoThe views expressed in this presentation are the authors and do not necessarily reflect the views of the manage-ment of the Federal Reserve Bank of San Francisco or any other individuals within the Federal Reserve System.1BackgroundJanuary 1961:JFK just inauguratedRecession (want to lower interest rates)But European interest rates higher than in U.S.,large gold outflows under Bretton Woods system

Solution:Lower long-term interest rates but keep short-term rates unchangedFed would sell short-term Treasury bills and buy longer-term notes and bondsTreasury would issue more short-term bills and fewer long-term notes and bonds.2Three MythsOperation Twist and QE2 are conceptually differentOperation Twist was smallOperation Twist had essentially no effect

Operation Twist vs. QE2Operation TwistQE2Large gold outflows prevent Fed from lowering funds rateZero lower bound prevents Fed from lowering funds rateBuy long-term Treasury securitiesBuy long-term Treasury securitiesSell/issue short-term Treasury billsIssue bank reserves (short-term Fed liabilities)4Operation Twist Was Big

5Three MythsOperation Twist and QE2 are conceptually differentOperation Twist was smallOperation Twist had essentially no effect

Operation Twist: Conventional WisdomLow-frequency (quarterly) time series analysisModigliani and Sutch (1966,1967)

Some inherent problems:Unobserved variables (expectations of future monetary policy, inflation)Large standard errorsEndogeneityEvent Study ApproachRe-examine Operation Twist using modern event studyAdvantages of event study approach:Other factors affecting macroeconomic outlook held constantStandard errors are smallerAvoids endogeneity problemsNo evidence of over- or under-response in Treasury market:Jones, Lumsdaine, Lamont (1998 JFE)Fleming and Remolona (1999 JoF)Advantages of Operation Twist period:No financial crisisForeign official purchases were tiny

Event Study: Markets Respond Quicklysource: Gurkaynak, Sack, and Swanson (2005)Event Study Approach

Event Study DatesHypothesis TestsH0: Operation Twist announcements had no effect on Treasury yieldsH1: A decrease in net supply of long-term bonds:Decreases long-term interest ratesMay raise short-term interest ratesDoes not lower short-term interest rates(Federal Reserve targets short-term interest rates)

Results

Comparison to the LiteratureModigliani-Sutch (1966)Gagnon et al. (2010)DAmico-King (2010)Hamilton-Wu (2010)Greenwood-Vayanos (2008)Krishnamurthy-Vissing-Jorgensen (2007)Warnock-Warnock (2009)< 20bp 14 to 30 bp100 bp17 bp10 to 16 bpN/A (6 to 16 bp)N/A (76 bp)Predicted effect of QE2 on long-term yieldsStudyComparison to a Funds Rate Surprise

source: Gurkaynak, Sack, and Swanson (2005)Results: Agency and Corporate Bond Yields

Small Response of Corporate Bond YieldsTwo main interpretations of this finding:Moodys Aaa and Baa indexes are illiquid, slow to respondCorporate bonds are not very good substitutes for TreasuriesCaveats of the illiquidity-based explanation:Quoted bond yields are functions of dealer bids & offersSerial correlation of Moodys Aaa and Baa indexes in 1962 are -.07 and -.10, respectively, inconsistent with under-responseKrishnamurthy and Vissing-Jorgensen (2011) find the same phenomenon for QE2Three MythsOperation Twist was different from QE2Operation Twist was smallOperation Twist had essentially no effect

ConclusionsOperation Twist was remarkably similar to QE2High-frequency event-study analysis: Operation Twist had highly statistically significant effect on Treasury yieldsBut the effect was moderate, about 15bpConsistent with lower end of range of estimates of Treasury supply effects in the literatureEffects of Operation Twist diminish as one moves away from Treasuries toward private credit markets

Markets in Fall 2008 Are Not Representative

source: Gurkaynak and Wright (2011)20Event Study Analysis of QE1 Is Problematic

21Theoretical MotivationTobin (1958): Portfolio Balance modelModigliani and Sutch (1966): Preferred Habitat model

Idea:Heterogeneous investors have different preferred habitatsArbitrage is limited (risk aversion, capital constraints)Decreasing supply of a security raises its price (reduces risk premium)

More recently:Greenwood and Vayanos (2008), Vayanos and Vila (2009)22