Williams quantitative-easing-and-treasury-markets

______________________________________________________________________________
The following report should not be construed as presenting any investments-related advice in any
form. The author(s) and any affiliated parties hereby accept no responsibility for any actions
taken or not taken by third parties based on the information provided in this report. Please direct
any questions to Michael R. Williams at mwilliams15@govst.edu.
The Impact of
Quantitative Easing on
US Treasury Markets
August, 2013
Prepared by:
Michael R. Williams
Governors State University
College of Business and Public Administration
mwilliams15@govst.edu

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- 1 -
Executive Summary
This study examines the impact of recent US Federal Reserve monetary stimulus on US Treasury
yields and, to a more limited extent, the Treasury/Equity cross-asset relationship. This study
reveals the following insights:
■ US Fed policy suppressed Treasury yields across the entire Yield Curve (...however...)
■ Lower-maturity yields were far more suppressed than longer-term yields
■ Equity prices were likely inflated due to the Fed's policies
■ Equity/Treasury price correlations became markedly negative after QE began
Additionally, this study makes the following, qualitative predictions regarding the ending of the
Fed's simulative measures:
■ Treasury Yields will likely increase across the entire maturity-spectrum with short-term
yields increasing (absolutely and relative to longer-term rates)
■ Equity prices will likely decline significantly
■ Recent cross-market relationships between the US equity and Treasury markets will
likely revert to pre-stimulus state thus eroding cross-asset diversification benefits

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- 2 -
Introduction
Under normal interest rate conditions, US Federal Reserve (Fed) monetary operations work by
directly impacting short-term rates with the hope that subsequent longer-term rates will be
affected. Yet, after facing the liquidity trap of effectively-zero real interest rates, the Fed enacted
a series of "extraordinary" measures known as Quantitative Easing and Operation Twist. The
chart below plots the cumulative net (buying minus selling) dollar volume of Fed Permanent
Open Market Operations (POMO) both for the amount submitted for transactions
(CumNetSubmitTTL; grey) as well as the amount accepted for transactions (CumNetAccptTTL;
black).
0
1,000,000
2,000,000
3,000,000
4,000,000
5,000,000
6,000,000
7,000,000
8,000,000
Jan-00
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CumNetSubmitTTL CumNetAccptTTL
While the impacts of the simulative measures are debatable, the clear impact of QE policies on
asset market dynamics is not. The purpose of this report is to detail the impact of QE policies on
various US Treasury rates, discuss the impacts of QE on cross-asset dynamics, and shed light on
possible future interest rate moves when the Fed QE policy is ended.

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- 3 -
Methodology
Publicly-available daily US Treasury yield data from 1/3/2000 to 6/14/2013 is used to build a
time-series econometric model of yield movements throughout time. Additional explanatory
variables used in this study include effective Federal Funds data from the Federal Reserve Bank
of St. Louis and Permanent Open Market Operations Data from the Federal Reserve Bank of
New York. The model used for analysis in this report is as follows:
titititititi LengthPurchaseAmtSubEFFy ,4,3,2,10,,  
where ∆yi,t is the yield change of a given US Treasury instrument, ∆EFFt is the change in
Effective Federal Funds Rate, AmtSubt is the amount submitted by the Fed via POMO (positive
for buying; negative for selling), Purchaset is an indicator variable equal to one (zero) for net
buying (selling) activity, and Lengtht is the time between the operation date and settlement date
of a given transaction.
Note that the purpose of this model is not parameter inference, as is typical in many econometric
applications. Rather, the purpose of the above model is to "filter" the original data series ∆yi,t. In
doing so, we can compare the difference between the raw series, which includes the impact of
the QE programs, and a filtered series that has the impact of the simulative programs stripped
away. Thus, inferences are made regarding what really happened (raw) and what would have
happened without the QE programs (filtered). Alternatively, the filtered series may be thought of
as what may be possible in the future when the Fed tapers its extraordinary stimulus measures.
Also note that the above model is qualitatively robust to model specification. This means that the
general inferences of this report are not sensitive to, for example, adding an own lag of treasury
yield changes or substituting accepted POMO activity for submitted POMO activity. Having said
that, all models are limited and those limitations should be clearly stated. Thus, readers should be
cautioned from drawing exact numerical inferences from the analysis presented below due to
model misspecification, parameter instability and sample length, data reporting error, omitted
variables, etc.

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- 4 -
Treasury Yield Impacts
The following charts plot the raw and filtered 13-week, 5-year, 10-year, and 30-year Treasury
yields. As noted above, the raw series (grey) is the actual data series that includes the impact of
the QE and Fed Funds stimulus whereas the filtered series (black) do not include the impacts of
Fed Funds changes and the QE programs.
0
1
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9
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US 13w (Raw) US 13w (Filtered)
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US 5y (Raw) US 5y (Filtered)
0
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As seen above, Treasury yields across the entire maturity-spectrum have been suppressed by the
Fed's actions. So, for example, the reported closing yield for the 10-year Treasury was 2.13% on
6/14/2013. Yet, once the Fed's impacts are filtered, the 10-year Treasury has an estimated yield
of 6.55%. Thus, regardless of its impacts on the overall economy, the Fed has impacted the US
Treasury market by suppressing interest rates. Not surprisingly, any tapering of the Fed's
simulative programs will likely lead to an increase of Treasury yields across the Yield Curve.

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- 5 -
An interesting observation seen in the above plots is that the greatest amount of rate suppression
has occurred in the shorter-maturity instruments. The following table reports the raw and filtered
yields along with the percentage point difference between the two (as of 6/14/2013).
Raw Filtered %Diff
0.04% 5.27% 5.23%
1.10% 6.46% 5.36%
2.13% 6.55% 4.42%
3.32% 6.62% 3.30%
Thus, once the Fed tapering begins, we can likely expect lower-maturity Treasuries to have a
greater rate increase, relative to longer-maturity Treasuries. Additionally, this may mean that the
currently-upward-sloping yield curve could flatten once the tapering begins.
More specifically on the last point, the following surface plot depicts the average yearly raw (i.e.
real world) Treasury yields observed since 2005. We can see that the Yield Curve was fairly flat
until around 2008 when the QE rounds began. From there, the Yield Curve increasingly
"twisted" upward.
13w
5y
10y
30y
201320122011201020092008200720062005
0
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Yield Curves (Raw) 0-1 1-2 2-3 3-4 4-5 5-6 6-7 7-8 8-9
The surface plot below depicts the average yearly filtered (i.e. QE effects subtracted) Treasury
yields (estimated) since 2005. We can see two main points. The first is that the entire surface plot
is shifted upwards indicating that the Fed policies had a rate-suppressing effect across the
maturity-spectrum and that stimulus tapering will likely lead to a rate increase across all
maturities.

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- 6 -
13w
5y
10y
30y
201320122011201020092008200720062005
0
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2
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Yield Curves (Filtered) 0-1 1-2 2-3 3-4 4-5 5-6 6-7 7-8 8-9
The second, and more important point is that, absent of Fed Funds and QE effects, the Yield
Curve would likely have been inverted for most of 2006-2007. Further, while the Yield Curve
slope would have reverted to a "normal" upward tilt in recent years, the actual slope would have
been less pronounced without the QE and Fed Funds policies.
Thus, the recent Fed policies not only shifted the entire Yield Curve downward, but they also
"twisted" the Yield Curve upwards more so than what could have been expected without the
simulative measures. Thus, Fed tapering of QE and the end of short-term rate suppression will
likely lead to an increase in all Treasury yields where the rate increases will likely be most
severe for shorter-maturity instruments.

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- 7 -
Cross-Market Impacts
While the main focus of this study is on the US Treasury market, the impact of the Fed's policies
have not been isolated to Treasuries alone. For example, the following chart plots the daily
closing values of the S&P 500 Index. This includes the raw S&P 500 Index values (grey) and the
"filtered" S&P 500 Index values (black; i.e. the estimated index value with Fed Funds and QE
impacts removed).
600
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S&P 500 (Raw) S&P 500 (Filtered)
As can be seen, the S&P 500 Index was not greatly impacted by changes in the Fed Funds rate
early on in the sample. However, a great upside divergence is seen after the beginning of the QE
programs where the actual S&P 500 Index is far above and beyond what the index "would have
been" without the stimulus. For example, as of 6/14/2013, the S&P 500 Index was 1,626.73
while the filtered Index was about 1,077.97. Based on an econometric model robust to sampling
window and model-specification, the S&P 500 Index is estimated to be around 33.7%
overvalued.
Additionally, according to a forthcoming book chapter, The Impact of Quantitative Easing on
Asset Price Comovement (2013; In Frontiers of Economics and Globalization: International
Financial Markets, forthcoming), equity and Treasury prices became increasingly negatively
correlated with each new round of QE. While this may seem like a blessing for diversification
purposes, uncertainty regarding future equity/Treasury correlations may negatively affect
unprepared traders once the Fed policies are tapered.

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- 8 -
Biography:
Michael Williams
Michael R. Williams is an Assistant Finance Professor at Governors State University, College of
Business and Public Administration. Michael has an undergraduate degree in Economics, an
MBA, a Masters in Economics, and PhD in Finance. His current interests include financial
futures and other, derivative asset markets. In addition to his teaching and research work at
Governors State University, Michael is also a quantitative advisor to Jack Broz of
TradeBondFutures.com.

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