The effect of quantitative easing on

interest rates

by Annette Vissing-Jorgensen and Arvind Krishnamurthy

Hanno Lustig

UC Berkeley Haas and UCLA Anderson

November, 2012

Second Annual Roundtable on Treasury Markets and Debt Management
Uncertainty

• did Fed reduce/create uncertainty in bond market during

QEI/II?

• large-scale experiment in monetary economics without

precedent in U.S.

• bond market participants face huge amount of model

uncertainty in assessing likely impact of QE and other

measures

‘The long-term risks are enormous but difficult to

estimate. They begin with the danger of a new

surge of inflation, at least after the economy

comes out of its current downturn. Beyond that,

taxpayers will have to pick up the losses from

loans that default or guarantees that have to be

made good.’

Source: U.S. Details $800 Billion Loan Plans, NYTimes,

Nov 25, 2008.
Measuring Tail Risk

• cost of tail risk insurance for actively traded bond portfolios

in option markets

• use volatility surface (OptionMetrics) for options on bond

ETF’s traded on CBOE

1. SHY: iShares Barclays 1-3 Year Treasury Bond Fund

2. TLT: iShares Barclays 20+Year Treasury Bond Fund

3. IEF: iShares Barclays 7-10 Year Treasury Bond Fund

4. LQD: iShares iBoxx Top Investment Grade Corporate Bond

Fund

5. TIP: iShares Barclays US Treasury Inflation Protected

Securities Fund
Tail Risk and Quantitative easing

• is the Fed reducing tail risk in the 10/20-year Treasury

market?

• initial increase in downside tail risk (large increase in

nominal yields) during QEI, but decreases in upside tail

risk (large drop in nominal yields)

1. Implied volatility from OTM puts on 360-day options for

10-year Treasury bonds increases by 10 percentage

points ; 15 percentage points for 20-year Treasury bonds.

2. Implied volatility from OTM calls on 360-day options for

10-year Treasury bonds decreases

3. Implied volatility from OTM puts on 360-day options for

TIPS decreases

• implied volatility on 10-year and 20-year Treasuries spikes

during QEI well after stock market vol spikes
Implied Vol in the Tails Increases During QEI

Figure : 360-day implied vol for 10-year Treasuries

May Jul Aug Oct Dec Jan Mar May

0.05

0.1

0.15

0.2

0.25

Implied Volatility−OTM 360−day Puts and Calls on IEF. |∆| =20

QEI

Puts

QEI

Calls

Figure : 360-day implied vol for 20-year Treasuries

May Jul Aug Oct Dec Jan Mar May

0.1

0.15

0.2

0.25

0.3

0.35

0.4

0.45

Implied Volatility−OTM 360−day Puts and Calls on TLT. |∆| =20

QEI

Puts

QEI

Calls

Puts and Calls with |∆| of 20.
QE in the media

Figure : Quantitative easing in News Articles

160 (340) mentions of ‘quantitative easing’ in the week (month) prior to 11/24

Source: Factiva. Mentions of QE prior to 11/24/2008 in major news outlets.
Implied Vol in the Tails During QEI

Figure : 360-day implied vol for 10-year Treasuries

May Jul Aug Oct Dec Jan Mar May

0.05

0.1

0.15

0.2

0.25

Implied Volatility−OTM 360−day Puts and Calls on IEF. |∆| =20

QEI

Puts

QEI

Calls

Figure : 360-day implied vol for TIPS

May Jul Aug Oct Dec Jan Mar May

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

Implied Volatility−OTM 360−day Puts and Calls on TIP. |∆| =20

QEI

Puts

QEI

Calls

Puts and Calls with |∆| of 20.
Implied Stock Market Vol in the Tails During QEI

Figure : 360-day implied vol for SPX

May Jul Aug Oct Dec Jan Mar May

0.2

0.25

0.3

0.35

0.4

0.45

0.5

0.55

0.6

0.65

Implied Volatility−OTM 360−day Puts and Calls on SPX. |∆|=20.

Puts and Calls with |∆| of 20.
Tail Risk and Quantitative easing

• is the Fed mitigating downside tail risk in the Treasury

market more than non-tail risk during QEI? evidence of a

Bernanke put?

• increase in downside risk (large increase in yields) during

QEI is smaller in the tails

1. Implied volatility from OTM puts for 20-year Treasury bonds

increases less than ATM implied vol

2. Implied volatility from OTM puts for 10-year Treasury bonds

increases less than ATM implied vol

3. Implied volatility from OTM puts for 3-year Treasury bonds

increases less than ATM implied vol

• during QEI, the Fed is steepening the inverse volatility

skew for Treasuries, putting the Bernanke put in place

• during QEII, the inverse volatility skew remains steep: the

Bernanke put is solidly in place
Steepening Volatility Skew during QEI for Treasuries

Figure : 360-day Put implied vol for 20-year Treasuries

20 30 40 50 60 70 80

0.24

0.26

0.28

0.3

0.32

0.34

0.36

0.38

0.4

0.42

|∆| Implied Vol

Implied Volatility from 360−day Puts on TLT

Post−QEI

QE1

Pre−QE1

Figure : 360-day Put implied vol for 10-year Treasuries

20 30 40 50 60 70 80

0.13

0.14

0.15

0.16

0.17

0.18

0.19

0.2

0.21

0.22

|∆| Implied Vol

Implied Volatility from 360−day Puts on IEF

Post−QEI

QE1

Pre−QE1

pre-window: 25 days-5 days before 1st; post-window: 5-25 days after last.
Steepening Volatility Skew during QEI for Treasuries

Figure : 360-day Put implied vol for 10-year Treasuries

20 30 40 50 60 70 80

0.13

0.14

0.15

0.16

0.17

0.18

0.19

0.2

0.21

0.22

|∆| Implied Vol

Implied Volatility from 360−day Puts on IEF

Post−QEI

QE1

Pre−QE1

Figure : 360-day Put implied vol for 3-year Treasuries

20 30 40 50 60 70 80

0.04

0.05

0.06

0.07

0.08

0.09

0.1

|∆| Implied Vol

Implied Volatility from 360−day Puts on SHY

Post−QEI

QE1

Pre−QE1

pre-window: 25 days-5 days before 1st; post-window: 5-25 days after last.
Steep Volatility Skew before, during and after QEII

Figure : 360-day Put implied vol for 20-year Treasuries

20 30 40 50 60 70 80

0.19

0.2

0.21

0.22

0.23

0.24

0.25

0.26

0.27

0.28

0.29

|∆| Implied Vol

Implied Volatility from 360−day Puts on TLT

Post−QEII

QE2

Pre−QE2

Figure : 360-day Put implied vol for 10-year Treasuries

20 30 40 50 60 70 80

0.1

0.12

0.14

0.16

0.18

0.2

0.22

|∆| Implied Vol

Implied Volatility from 360−day Puts on IEF

Post−QEII

QE2

Pre−QE2

pre-window: 25 days-5 days before 1st; post-window: 5-25 days after last.
Conclusion

• around start of QEI, inflation-driven uncertainty increases

in bond market:

• large increase in downside tail risk/uncertainty (risk of high

nominal yields) in Treasury market

• no similar increase in upside tail risk/uncertainty (risk of low

nominal yields) in Treasury market

• large decrease in downside tail risk/uncertainty (risk of high

real yields) in TIPS market

• around the end of QEI, Fed manages to mitigate increases

in downside tail risk relative to non-tail risk: the market

prices in a Bernanke put

• no increase in bond market uncertainty around QEII