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

and Its Implications for QE2

Stanford Macro SeminarApril 4, 2011

Eric T. SwansonFederal Reserve Bank of San Francisco

The views expressed in this presentation are the author’s 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.

BackgroundJanuary 1961:• JFK just inaugurated

• Recession (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

unchanged

• Fed would sell short-term Treasury bills and buy longer-term notes and bonds

• Treasury would issue more short-term bills and fewer long-term notes and bonds.

Three Myths

•Operation Twist and QE2 are conceptually different

•Operation Twist was small

•Operation Twist had essentially no effect

Operation Twist vs. QE2

Operation Twist QE2

Large gold outflows prevent Fed from lowering funds rate

Zero lower bound prevents Fed from lowering funds rate

Buy long-term Treasury securities

Buy long-term Treasury securities

Sell/issue short-term Treasury bills

Issue bank reserves (short-term Fed

liabilities)

Operation Twist Was Big

Three Myths

•Operation Twist and QE2 are conceptually different

•Operation Twist was small

•Operation Twist had essentially no effect

Operation Twist: Conventional Wisdom

Low-frequency (quarterly) time series analysis

Modigliani and Sutch (1966,1967)

Some inherent problems:• Unobserved variables (expectations of future monetary

policy, inflation)• Large standard errors• Endogeneity

Event Study Approach

Re-examine Operation Twist using modern event study

Advantages of event study approach:• Other factors affecting macroeconomic outlook held constant• Standard errors are smaller• Avoids endogeneity problems

No 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 crisis• Foreign official purchases were tiny

Event Study: Markets Respond Quickly

source: Gurkaynak, Sack, and Swanson (2005)

Event Study Approach

Event Study Dates

Hypothesis Tests

H0: Operation Twist announcements had no effect on

Treasury yields

H1: A decrease in net supply of long-term bonds:• Decreases long-term interest rates• May raise short-term interest rates• Does not lower short-term interest rates(Federal Reserve targets short-term interest rates)

Results

Comparison to the Literature

Modigliani-Sutch (1966)

Gagnon et al. (2010)

D’Amico-King (2010)

Hamilton-Wu (2010)

Greenwood-Vayanos (2008)

Krishnamurthy-Vissing-Jorgensen (2007)

Warnock-Warnock (2009)

< 20bp

14 to 30 bp

100 bp

17 bp

10 to 16 bp

N/A (6 to 16 bp)

N/A (76 bp)

Predicted effect of QE2 on long-term yieldsStudy

Comparison 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:• Moody’s Aaa and Baa indexes are illiquid, slow to respond• Corporate bonds are not very good substitutes for Treasuries

Caveats of the illiquidity-based explanation:• Quoted bond yields are functions of dealer bids & offers• Serial correlation of Moody’s Aaa and Baa indexes in 1962 are

-.07 and -.10, respectively, inconsistent with under-response• Krishnamurthy and Vissing-Jorgensen (2011) find the same

phenomenon for QE2

Three Myths

•Operation Twist was different from QE2

•Operation Twist was small

•Operation Twist had essentially no effect

Conclusions• Operation Twist was remarkably similar to QE2

• High-frequency event-study analysis: Operation Twist had highly statistically significant effect on Treasury yields

• But the effect was moderate, about 15bp

• Consistent with lower end of range of estimates of Treasury supply effects in the literature

• Effects 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)

Event Study Analysis of QE1 Is Problematic

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11/10 11/12 11/13 11/14 11/17 11/18 11/19 11/20 11/21 11/24 11/25 11/26 11/28 12/1 12/2 12/3 12/4 12/5

perc

ent

10-year Treasury Yield, Fall 2008WSJ/Hilsenrath: "Fed officials considering new lending facilities, more action on the federal runds rate, and purchases of long-term debt such as Treasury bonds or Fannie Mae and Freddie Mac debt to bolster markets and the economy"

Fed announces$500B MBS purchases $100B GSE debt purch.

Bernanke says Fed could purchase long-term Treasuries

Very weak ISM survey,data from UK, China, Dow falls 679 pts.

Gagnon et al.Event Date #1

Gagnon et al.Event Date #2

Theoretical Motivation

Tobin (1958): “Portfolio Balance” modelModigliani and Sutch (1966): “Preferred Habitat” model

Idea:• Heterogeneous investors have different preferred habitats• Arbitrage 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)