Term Structure Modeling with Supply Factors and the Federal Reserve's Large-Scale Asset Purchase Programs

This 2013 International Journal of Central Banking paper by Canlin Li and Min Wei asks whether changes in the supply of Treasury securities and agency mortgage-backed securities (MBS) affect nominal Treasury yields, and uses the answer to evaluate the Federal Reserve’s large-scale asset purchase (LSAP) programs. The authors build a no-arbitrage affine Gaussian term-structure model, motivated by the Vayanos-Vila (2009) preferred-habitat framework, whose state vector consists of two observable yield factors (the level, proxied by the 5-year yield, and the slope, the 5-year-minus-1-month spread, which together capture over 99% of yield variation) plus three observable supply factors: the Treasury ten-year-equivalents-to-GDP ratio, the agency-MBS par-to-GDP ratio, and MBS average duration. The model is deliberately restricted so the short rate loads only on the yield factors and supply factors carry zero own risk premium, meaning supply shocks affect yields only through the term premium and not through interest-rate expectations (the signaling channel is shut down by construction); the model is estimated by a two-step Ang-Piazzesi (2003) procedure on monthly pre-crisis data from March 1994 to July 2007. In-sample, supply factors are significantly and positively related to the term premium (reduced-form R-squared up to 0.89), a one-percentage-point decline in the Treasury ten-year-equivalents-to-GDP or MBS par-to-GDP ratio lowers the 10-year Treasury yield by roughly 10 basis points, a one-year shortening of average MBS duration lowers it by roughly 7 basis points, and supply factors account for about 9% (5-year) and 20% (10-year) of conditional term-premium variance at a 60-month horizon. Applying the estimated model out-of-sample to evaluate the Fed’s 2008-2012 asset purchases, and using the authors’ preferred approach that treats each program as a gradually implemented supply shock that investors expect to be partly reversed by future asset sales, the paper finds LSAP1 lowered 2-/5-/10-year Treasury yields by about 16/52/60 basis points, LSAP2 by about 2/13/19 basis points, and the Maturity Extension Program (MEP) by about 2/13/19 basis points, for a combined 10-year effect of roughly 100 basis points — the paper’s headline number. The authors are explicit that the model captures only the term-premium channel of LSAPs by construction, that estimates are sensitive to assumptions about the pace and timing of expected future asset sales, and that the model is fit on a pre-crisis sample and then applied out-of-sample to the very different 2008-2012 period.

Min Wei | Macro Paper Warehouse

Term Structure Modeling with Supply Factors and the Federal Reserve's Large-Scale Asset Purchase Programs