Drivers and Determinants of Liquidity Across

Sectors and Implications for Systemic Risk

Jon Kinol, Credit Suisse

Discussion by

Jens H. E. Christensen

Federal Reserve Bank of San Francisco

13th IMF Public Debt Management Forum

&

3rd Roundtable on Treasury Markets and Debt Management

Washington D.C., June 20, 2013

The views expressed here are solely the responsibility of the author and should not be interpreted as reflecting the views

of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System.

1 / 10
Efficiency and Liquidity of Treasury and TIPS Markets

2005 2006 2007 2008 2009 2010 2011 2012 2013

0 200 400 600 800 1000

Billions of dollars

Lehman Brothers

Bankruptcy

Sept. 15, 2008

QE2

Program

Treasuries trading volume, weekly average 

Treasuries trading volume, 8−week moving average 

2005 2006 2007 2008 2009 2010 2011 2012 2013

0 5 10 15 20 25

Billions of dollars

Lehman Brothers

Bankruptcy

Sept. 15, 2008 QE2

Program

TIPS trading volume, weekly average 

TIPS trading volume, 8−week moving average 

The Treasury market is a mature giant, while the TIPS market is a

growing enfant in comparison.

First, I discuss some issues related to the efficiency of pricing in the

Treasury market.

Second, I introduce a measure of liquidity premiums in the TIPS and

inflation swap markets relative to the Treasury market and show how

the TIPS purchases included in the Fed’s QE2 program affected the

functioning of these markets. 2 / 10
Example: Fair Value of Fed’s Treasury Portfolio

Value in billions as of April 24, 2013 Maturity No.

Face value Bloomberg Model

All 245 1,744.06 2,042.34 2,061.44

3 years or less 89 66.13 70.61 71.53

4-6 years 79 669.47 742.49 750.00

7-10 years 39 599.89 692.64 695.52

11 or more years 38 408.57 536.59 544.40

Christensen, Lopez, and Rudebusch (2013) analyze the fair

value of the Fed’s Treasury securities holdings.

To do so, we use the Gaussian shadow-rate arbitrage-free

Nelson-Siegel (AFNS) term structure model derived in

Christensen and Rudebusch (2013).

This class of models respects the zero lower bound for

nominal yields.

The model is estimated with Treasury yields from Gürkaynak,

Sack, and Wright (2007). Note its pricing is accurate

compared to Bloomberg data, but with a slight positive bias or

overpricing ... 3 / 10
Evidence of Mispricing in the Treasury Market

0 5 10 15 20 25 30

−6 −5 −4 −3 −2 −1 0 1

Time to maturity in years

Pricing error per 100 dollar notional

0 2 4 6 8 10 12

−6 −5 −4 −3 −2 −1 0 1

Coupon rate in percent

Pricing error per 100 dollar notional

Illustration of pricing errors in dollars per $100 notional across bond

maturities (left) and bond coupon rates (right).

Even as of April 24, 2013, some pricing errors are notable despite

high market liquidity and trading volume.

Implication: Securities with identical cash flows are trading at very

different prices! Most mispricing are for seasoned securities.

Is this a problem for the sovereign issuer? 4 / 10
What Does it Take to Affect TIPS Liquidity?

2005 2006 2007 2008 2009 2010 2011 2012 2013

0 1 2 3

Rate in percent

Lehman Brothers

Bankruptcy

Sept. 15, 2008

QE2

Program

Five−year liquidity premium 

Ten−year liquidity premium 

Christensen and Gillan (2012) demonstrate that the difference btw.

TIPS breakeven inflation and inflation swap rates represents the sum

of frictions (i.e., liquidity premiums) relative to the Treasury market.

TIPS purchases included in Fed’s QE2 program provides a natural

experiment for studying purchase effects.

Christensen and Gillan (2013) document that these purchases led to

significant declines in the frictions in these two markets. 5 / 10
Fed’s QE2 TIPS Purchases

2008 2009 2010 2011 2012

0 20 40 60 80 100

Billions of dollars

QE2

Program

Total book value 

Total face value 

0 5 10 15 20 25 30

0 10 20 30 40

Bond maturity in years

Market share in percent

Market share as of Nov. 3, 2010 

Market share as of Jun. 29, 2011 

The chart to the left shows the book and face value of the

Fed’s holdings of TIPS around the time of QE2.

QE2 increased Fed’s TIPS holdings by 53 percent.

The chart to the right shows the percentage of outstanding

TIPS held by the Fed at the beginning and at the end of QE2.

Fed only held moderate fractions of individual TIPS.

6 / 10
Fed’s QE2 TIPS Purchases cont. 11/23/2010 12/8/2010 12/21/2010 1/4/2011 1/18/2011 2/1/2011 2/14/2011 3/4/2011 3/18/2011 3/29/2011 4/20/2011

5/4/2011

5/16/2011

6/7/2011

6/17/2011

Total market 

4−6 year sector 

8−10 year sector 

Ratio in percent

0.0 0.2 0.4 0.6 0.8 1.0 1.2

This chart shows the size of the 15 TIPS purchase operations both

relative to the total TIPS market and relative to relevant maturity

segments of the TIPS market.

TIPS purchases were concentrated in the 8-10 year segment.

What is the effect of buying one percent of a given segment of the

TIPS market? 7 / 10
Regression Results with Weighted Purchase Dummy

CG (2012) measure Explanatory Variables

5-year 10-year

Constant 3.16 23.91

(1.23) (9.82)

VIX 1.35 0.16

(21.76) (2.50)

Off-The-Run Spread -0.68 0.52

(-5.88) (8.83)

AAA Credit Spread 0.32 0.09

(19.96) (6.04)

IS Bid-Ask Spread 0.99 1.08

(7.61) (6.20)

TIPS Trading Volume -1.92 -2.66

(-8.01) (-9.41)

TIPS Purchase Dummy 8.47 28.61

4-6 Year Sector (0.37) (1.30)

TIPS Purchase Dummy -15.37 -14.56

8-10 Year Sector (-3.43) (-3.31)

Adjusted R

2

0.81 0.50

Liquidity premium measure declines by about 15 basis points

for each percent of the TIPS market purchased. 8 / 10
Counterfactual Exercise −50 −40 −30 −20 −10 0 10 20 Rate in basis points

November January March May July

First TIPS purchase

Nov. 23, 2010

Last TIPS purchase

Jun. 17, 2011

Five−year observed over counterfactual 

Ten−year observed over counterfactual 

We use regression results up to Nov. 2, 2010, to generate a

counterfactual for the liquidity premium measure during QE2.

The chart above shows the difference btw. the observed and

counterfactual series.

Results indicate that frictions in the TIPS and inflation swap markets

were reduced from where they would otherwise have been with a

peak effect of more than 30 basis points around the middle of QE2.

Equally important, effect vanished as purchases tapered off. 9 / 10
Conclusion

Mispricing of very seasoned securities with non-current

coupon sizes is widespread in the highly liquid U.S. Treasury

market, even under optimal market conditions:

1 Is this a problem for the sovereign issuer?

2 This could provide a benchmark for what to expect in other

markets regarding pricing of seasoned bonds.

3 Also, mispricing is not an adequate statistic for assessing

market functioning or market liquidity.

The TIPS market might serve as a more useful benchmark for

some of the larger sovereign debt markets around the world

as measured by size and trading volume:

1 Frictions in the markets for TIPS and inflation swaps are

sensitive to trading volume or so-called purchase effects.

2 The Fed’s QE2 TIPS purchases represented less than 5

percent of the TIPS market. Still, they reduced our measure of

frictions in these markets by about 12-14 basis points on

average for the duration of the program.

3 Thus, even relatively small initiatives or improvements might

provide surprisingly large gains.

10 / 10