Liquidity Effects in the Bond Market

Abstract

Our paper reports the following two findings: 1) In monthly data, bond purchases by the Fed raise bond prices and reduce bond yields. The residual bond-supply to traders is not fully predictable, and this supply-risk adds between 10 and 40 basis points to the standard deviation of the real interest rate on T-bills. 2) The Fed's open market purchases do not raise stock prices or reduce stock returns. If anything, they raise stock returns. More generally, bonds and stocks do not co-move at high frequencies. To explain these two facts, we model the bond and stock markets as spatially separate or 'segmented'. In the model, bond purchases lower bond rates, but they do not affect stock returns, and this is consistent with both facts.