US Treasuries: Was the Fed’s purchase programme a success?

The effectiveness of the Federal Reserve’s $300 billion Treasury securities purchase programme has been subject to much scrutiny since its launch in March. But as former Fed governor Laurence Meyer explains, the debate should extend beyond a simple analysis of the effect on yields.

The Federal Reserve’s $300 billion Treasury securities purchase programme, announced on March 18, 2009, has been a bone of contention since its inception. The scheme was intended to “improve conditions in private credit markets”, but its effectiveness has been a source of considerable disagreement, both inside and outside of the Federal Open Market Committee (FOMC). With the initiative ending on October 29, has the programme actually accomplished its goal?

Many have argued that the relatively quick backtracking in Treasury yields in the weeks following the Fed’s announcement of its Treasury securities purchases is evidence the programme did not achieve its aim of improving credit conditions. An alternative view is that there could have been other factors – such as an improving economic outlook, new issuance and the return of investor risk appetite – that pushed Treasury yields higher over that period. While it is difficult to quantify the importance of those factors, our analysis suggests some could have been significant enough to cast doubt on the conclusion that the Fed’s purchase of Treasuries was ineffective.

Paradoxically, the mere creation of the programme, along with the simultaneous expansion of the Fed’s agency securities purchases, likely contributed to the subsequent rise in Treasury yields. The higher yields may have been the result of greater risk appetite, presumably as market participants came to see the asset purchase programmes as yet another indication the Fed was willing to act decisively to counter the effects of the crisis. Under this interpretation, the purchase programme was indeed effective, even if its net effect was a rise in Treasury yields.

Within the context of this debate, it is important to look at the movements in Treasury yields around the time of the announcement of the programme and consider the basic argument against its effectiveness. The 10-year Treasury yield dropped roughly 50 basis points on the day of the announcement. In the same press release, the Fed announced a sizable expansion of its MBS purchase programme. Nonetheless, it took only five weeks for the 10-year yield to return to its pre-announcement level.

Under the influence

There are three possible factors that could have influenced the level of Treasury yields during that period: investors’ views of the outlook; risk preferences; and the supply of Treasuries. To gauge the impact of each factor, one must first consider whether changes to each were at least qualitatively consistent with the rise in Treasury yields during the five-week period during which yields backtracked.

It could be that incoming economic data over the weeks immediately following the Fed’s announcement led to upward revisions in market participants’ expectations of growth and inflation, which in turn would be reflected in higher Treasury yields. The question then becomes: were investors generally surprised by the strength of the incoming data?

One tool that can help assess whether the movement in yields at the time could be justified by changes in market participants’ outlook is our economic news index. That index did not change materially over the five-week period in question. This suggests investors’ views of the economy, at least to the extent those views were shaped by incoming data, were not a major driver of movements in the 10-year Treasury yield.

If it wasn’t the incoming economic data, could it be that yields were pushed higher by record supply? After all, empirical evidence suggests that news related to increased issuance tends to push yields higher. The Treasury’s issuance of new coupon securities increased dramatically last spring. Net issuance in March was, at the time, the largest on record.

However, one potential problem with attributing the reversal in Treasury yields to supply factors is there was little news about the upcoming supply of securities during that time. In particular, we have not been able to find any factors, such as higher-than-expected auction sizes or surprises at quarterly refundings, that would help better measure the importance of supply effects on yields during that period. Although the market’s ability to absorb new issuance certainly remained a concern, it is difficult to provide concrete evidence that the rise in yields then was a response to supply pressures.

As for the third possible factor – a change in attitudes towards risk – it is well known the financial crisis resulted in extreme risk aversion in the marketplace. This manifested itself in sharp increases in demand for the safety and liquidity of newly issued nominal Treasury securities. One possible explanation for the rise in yields during our reference period is that those flight-to-quality flows into Treasuries were beginning to unwind.

Changes in three proxies for market participants’ attitudes towards risk and liquidity around the time of the Fed announcement – each from a different corner of the financial markets – can be used as indicators of changing risk appetite.

The first, the three-month Libor/Overnight Indexed Swap spread, is a barometer of conditions in the interbank lending market. That spread had been widening in the weeks leading up to the Fed announcement, but it abruptly reversed on the announcement, beginning a period of sustained improvement.

A qualitatively similar story applies to the yield spread between off- and on-the-run 10-year Treasuries, which are a measure of investors’ liquidity preferences. Although that spread started narrowing a few days before the Fed announcement, the pace of narrowing picked up considerably after the announcement.

In addition, the Wilshire 5000 index, which reflects the market value of all actively traded stocks in the US, gained about 10% during the five-week period that followed the Fed’s press release. Stocks had been trending higher for a few days prior to the announcement.

When looking at conditions in the corporate debt market, proxied here by changes in credit default swap indexes, the CDX IG and CDX HY, both indicators of CDS spreads, narrowed substantially in the weeks after the Fed announcement, with the immediate and narrowing of the investment grade index especially noteworthy.

With a broad improvement in risk conditions around the time of, and especially after, the Fed announcement, one can reasonably infer such a trend would be at least qualitatively consistent with reduced demand for the liquidity and safety of Treasury securities. This in turn could have led to increases in Treasury yields.

Another interesting inference we can draw is that the noticeable improvement in conditions in the credit and equity markets in the weeks after the Fed announcement could have been attributable to the announcement itself. However, any analysis would have to consider the announcement as referring to both the inception of the Treasuries purchase programme and the expansion of the agency securities purchase initiative.

The bigger picture

What does seem apparent is the timing of the turnaround in some of the risk proxies roughly coincides with the Fed’s announcement. This suggests the announcement could have lowered risk spreads by having a confidence-building effect. Accordingly, it is possible the FOMC’s decision to engage in large-scale purchases of longer-dated Treasuries, as well as to expand its purchases of agency securities, was viewed as an impressive show of force. That decision underscored the FOMC’s willingness to do whatever it took to ease financial conditions despite the non-negativity constraint on nominal interest rates.

If this assessment is right, it would be unwise to point to the quick reversal in Treasury yields in the weeks after the Fed’s announcement as proof the programme failed to achieve its goal to “improve conditions in private credit markets”. Furthermore, the takeaway for market participants from this would be to not simply focus on Treasury yields but to look at broader credit market indicators. Looking at the bigger picture, one might conclude the Fed’s Treasuries purchase initiative was effective, even if its net result was a subsequent increase in Treasury yields.

Laurence H. Meyer is a co-founder and the vice-chairman of Macroeconomic Advisers, a US macro research firm. He was a governor of the Federal Reserve Board from 1996–2002