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)