The Return of Portfolio Balance Models: “The Large Scale Asset Purchases Had Large International Effects”

In a new working paper, the St. Louis Fed’s Christopher Neely argues The Large Scale Asset Purchases Had Large International Effects.

The Federal Reserve’s large scale asset purchases (LSAP) of agency debt,
MBSs and long-term U.S. Treasuries not only reduced long-term U.S. bond yields also
significantly reduced long-term foreign bond yields and the spot value of the dollar. …

… These
changes were much too large to have been generated by chance and they closely followed LSAP
announcement times. These changes in U.S. and foreign bond yields are roughly consistent with
a simple portfolio choice model. Likewise, the exchange rate responses to LSAP announcements
are roughly consistent with a UIP-PPP based model. The success of the LSAP in reducing longterm
interest rates and the value of the dollar shows that central banks are not toothless when
short rates hit the zero bound.

This is an important finding because it re-affirms the scope for Fed policy even when the Fed Funds rate has hit zero. It also buttresses the results of Gagnon et al., showing that Fed purchases of long term bonds did have an impact on long term interest rates.

I’ve discussed the portfolio balance model in the past, noting the limited success in estimating risk premia. [1] [2] [3]. The Fed LSAPs have constituted an experiment (albeit not completely controlled) of unprecedented size, and that large variation is what was needed in order to obtain evidence in favor of the portfolio balance model.

How do the predictions of [the] simple portfolio model compare to the actual
changes in observed prices? Recall that the simple model predicted that a 22 percent reduction
in the quantity of U.S. debt outstanding would increase expected real U.S. bond returns by 178
basis points and foreign expected real returns (in U.S. goods) by 100 to 160 basis points. These
estimates are subject to uncertainty because the mean and covariance of returns must be
estimated and because the number of assets is limited. 11 If the LSAP did not change inflation
expectations, then these expected real returns translate directly into expected nominal returns.
Table 2 showed that 10-year U.S. Treasury yields fell by 107 basis points over the 5
“buy” announcement windows. The troubled state of global credit markets in the autumn of
2008 meant that long-term high-quality asset prices were already very high, by historical standards, when the LSAP was announced. Given the existing high prices caused by low risk
tolerance, the actual falls in U.S. Treasury prices seem reasonably consistent with the very
simple model’s predictions.

The model incorporates “risk-adjusted” uncovered interest parity (including at the 10 year horizon, which is consistent with Chinn-Meredith (2004) [4]) and long run purchasing power parity — so that the Dornbusch overshooting effect holds. Figure 7 from the paper depicts the impact on the dollar’s value.


Figure 7 from Neely (2010).

These results clearly have policy implications, above and beyond expanding our understanding of how international financial markets work. In particular, they suggest that the Fed can affect the value of the dollar even if the policy rate has hit zero — something I had wondered about previously [5] [6] [7]. It also reminds us that, as the economy’s rebound weakens, monetary policy can still offset (some of) the effects of ill-advised attempts by some to withdraw fiscal stimulus. [8] [9] [10] (That last point is my view, and not in the paper).

13 thoughts on “The Return of Portfolio Balance Models: “The Large Scale Asset Purchases Had Large International Effects”

  1. ppcm

    No doubts that CBs are not toothless when it comes to act on long term yield curves
    For the ways and methods (Econbrowser several previous posts have quiet extensively touched upon the subjects)
    Long-Term Composite Rate of U.S. Treasury Securities Over 10 years (DISCONTINUED SERIES)
    Euro bund is similar (to reach the same homothetic curves in time and days, actions must be in good sequential orders and the means abundant)
    I wonder whether the Banks stress tests in Europe will include an audit (legal) of the binding contracts between banks and central banks and of the supportive financial assets as well.
    Bloomberg article is interesting
    European Banks Poised to Win Reprieve on Capital Rules
    By Yalman Onaran and Simon Clark – Jul 12, 2010
    When reading the above graphs shall it be understood that risk is a given constant and there are no alternative to the same risk?

  2. don

    It seems Ben has stolen another march on the ECB. That, in my opinion, is an extremely short sighted policy. The stress from loss in competitiveness caused by $1.50 per euro (which also caused Europe to become China’s primary market) surely did not help the PIIGS.
    True, the euro area probably cannot survive its own internal imbalances, at least not in its current form, but it is also true that Chimerica is simply to big to lever itself up on the back of Europe. Trying to do so will merely risk bringing Europe down and exacerbating our own problems.
    My guess is, Triche will remain clueless, with the result that European countries will impose trade sanctions on Asian currency manipulators.
    I wonder if Krugman will be dismayed to see them take his advice in this endeavor (“Go, Schumer”)while ignoring his advice on fiscal stimulus?

  3. ppcm

    The break up of the euro is more a muse for the financial press, the tabloid financiers, than an economic reality. A reminder of the European monetary snake (SMI), strongly feared and denied around the Forex tables as a potential ” business” starver.In the late 90s, playing the divergences among the currencies constituents of the SMI was the flavor of the day .The euro is in circulation but I am not sure of the same for the punters.
    Through last posts of Econbrowser (Is Spain next) comments were made on the drawback of a euro break up .At this juncture one may wish it only, if to satisfy a material and financial masochism where the UK will be the first beneficiary (see BIS statistics report on cross boarder loans).
    Economic balancing is not supportive of a euro break up.The capital markets have more to fear from the computers hardwares and the softwares programmers, than from the mere existence of any currency symbol on a Bloomberg clavier.

  4. RicardoZ

    The basic premise to all such studies is that lower interest rates are always good for the economy. This basic premise is never questioned. But have lower interest rates actually improved the economy?
    Most studies I see (example John Taylor) say that the actual interest rate should be negative perhaps -5%. I have not worked through the mechanism but it seems to be that the FED forcing down interest rates has actually lowered real interest rates below zero and the implication of this is deflation. By pushing down interest rates the FED is actually creating deflation while attempting to correct deflation with monetary easing to generate inflation. The FED is caught in a Keynesian Catch 22.
    The FED’s LASP program has created all kinds of unintended negative consequences, and they seem to be in confusion over their “exit strategy.” Is there any way out without disaster? We have only seen the tip of the iceberg floating in the path of the ship of state and the “experts” have discarded all the life boats.

  5. RicardoZ

    Menzie wrote:
    This is an important finding because it re-affirms the scope for Fed policy even when the Fed Funds rate has hit zero.
    This sentence by Menzie is not unusual in Keynesian ranks, as a matter of fact similar thoughts were expressed by Keynes himself, but what is missed in the is that it is essentially an admission of failure of the system itself. It cannot work before the bounds prevent it.
    Since it is recognized that the interest rate manipulations will not work because of the zero bound limit other manipulations are proposed once the limit is reached. If these other manipulations are so effective why not use them first?
    The entire system is based on a faith that has less foundation than blind faith because of the admission that the system actually does not work. Is it possible to expand the definition of insanity to include doing things based on the same failed theories expecting a different result?
    If zero interest rates do not work what is the rationale that driving them negative will work any better?

  6. MikeR

    With a zero rate lower bound and the need to supply additional liquidity and encourage bank lending, the monetary policy is working better than we could have hoped.
    It would be interesting to see an analysis of the effectiveness of these monetary measures compared to the fiscal stimulus measures.

  7. PS

    Focusing on the interest rate, the effect seems very short-lived: 10yr treasury yield dropped about 50 bps on the announcement but reversed all and some within a month. In fact, 10yr yield has been higher than that at the announcement for since May last year until the recent rally.

  8. RicardoZ

    You buy into the road to serfdom, either monetary stimulus or fiscal stimulus. Believe it or not there actually is another way.

  9. But What Do I Know?

    >>>The Federal Reserve’s large scale asset purchases (LSAP) of agency debt, MBSs and long-term U.S. Treasuries not only reduced long-term U.S. bond yields also significantly reduced long-term foreign bond yields and the spot value of the dollar. … )

  10. Chris Neely

    @But What do I know?
    It is certainly true that 10-year Treasury yields rose from late March to early June 2009 but that doesn’t tell us anything about the LSAP’s effect except that bond yields change for many reasons.
    No one should ever claim that an asset purchase means that asset prices stay permanently high despite any other influence. The asset purchase has an effect — and that effect continues — but other factors still act on bond prices and can certainly outweight the effect of the asset purchase.
    It is perfectly legitimate to try to explain longer-term bond price movements in mid-2009 but this paper was on the narrower question of what effect the LSAP had.
    I haven’t considered the question carefully, but Treasury yield might have increased from late March to early June because markets’ long-term GDP growth forecasts increased. Such an increase in expectations is consistent with the rise in the S&P 500 over the same period.
    (Again, rising growth forecasts is just my initial guess.)
    Here is the Treasury and S&P data if you’d like to graph it yourself.
    DGS10 10-Year Treasury Constant Maturity Rate (DGS10), Percent, Daily, Not Applicable
    SP500 S&P 500 Index (SP500), Index, Daily, Not Applicable
    Frequency: Daily
    observation_date DGS10 SP500
    2009-03-02 2.91 700.82
    2009-03-03 2.93 696.33
    2009-03-04 3.01 712.87
    2009-03-05 2.83 682.55
    2009-03-06 2.83 683.38
    2009-03-09 2.89 676.53
    2009-03-10 2.99 719.60
    2009-03-11 2.95 721.36
    2009-03-12 2.89 750.74
    2009-03-13 2.89 756.55
    2009-03-16 2.97 753.89
    2009-03-17 3.02 778.12
    2009-03-18 2.51 794.35
    2009-03-19 2.61 784.04
    2009-03-20 2.65 768.54
    2009-03-23 2.68 822.92
    2009-03-24 2.68 806.12
    2009-03-25 2.81 813.88
    2009-03-26 2.76 832.86
    2009-03-27 2.78 815.94
    2009-03-30 2.73 787.53
    2009-03-31 2.71 797.87
    2009-04-01 2.68 811.08
    2009-04-02 2.77 834.38
    2009-04-03 2.91 842.50
    2009-04-06 2.95 835.48
    2009-04-07 2.93 815.55
    2009-04-08 2.86 825.16
    2009-04-09 2.96 856.56
    2009-04-13 2.88 858.73
    2009-04-14 2.80 841.50
    2009-04-15 2.82 852.06
    2009-04-16 2.86 865.30
    2009-04-17 2.98 869.60
    2009-04-20 2.88 832.39
    2009-04-21 2.94 850.08
    2009-04-22 2.98 843.55
    2009-04-23 2.96 851.92
    2009-04-24 3.03 866.23
    2009-04-27 2.95 857.51
    2009-04-28 3.05 855.16
    2009-04-29 3.12 873.64
    2009-04-30 3.16 872.81
    2009-05-01 3.21 877.52
    2009-05-04 3.19 907.24
    2009-05-05 3.20 903.80
    2009-05-06 3.18 919.53
    2009-05-07 3.29 907.39
    2009-05-08 3.29 929.23
    2009-05-11 3.17 909.24
    2009-05-12 3.17 908.35
    2009-05-13 3.11 883.92
    2009-05-14 3.10 893.07
    2009-05-15 3.14 882.88
    2009-05-18 3.22 909.71
    2009-05-19 3.25 908.13
    2009-05-20 3.19 903.47
    2009-05-21 3.35 888.33
    2009-05-22 3.45 887.00
    2009-05-26 3.50 910.33
    2009-05-27 3.71 893.06
    2009-05-28 3.67 906.83
    2009-05-29 3.47 919.14
    2009-06-01 3.71 942.87
    2009-06-02 3.65 944.74
    2009-06-03 3.56 931.76
    2009-06-04 3.72 942.46
    2009-06-05 3.84 940.09
    2009-06-08 3.91 939.14
    2009-06-09 3.86 942.43
    2009-06-10 3.98 939.15
    2009-06-11 3.88 944.89
    2009-06-12 3.81 946.21
    2009-06-15 3.76 923.72
    2009-06-16 3.67 911.97
    2009-06-17 3.68 910.71
    2009-06-18 3.86 918.37
    2009-06-19 3.79 921.23
    2009-06-22 3.72 893.04
    2009-06-23 3.65 895.10
    2009-06-24 3.72 900.94
    2009-06-25 3.55 920.26
    2009-06-26 3.52 918.90
    2009-06-29 3.51 927.23
    2009-06-30 3.53 919.32
    I’m happy to civilly discuss these issues with people of all backgrounds — the snark about not having a doctorate in economics is not necessary.

  11. But What Do I Know?

    @ Chris Neely You’re right about the snark–I apologize.
    I will read your paper to look further into this–this question of determining cause and effect on prices is a difficult one and I agree that there could be many other factors that explain why Treasury bond yields rose. However, I still don’t understand why you feel that QE 1 could have caused a rise in bond prices when the effect appeared to be completely opposite.
    It seems to me that the nightmare scenario for the Fed vis-a-vis QE is that the one asset they cannot increase the price of is Treasury bonds. This might make sense if we think of Treasury bonds as cash-like assets (and cash-like assets are the ones that ought to be hurt by QE, since it creates more cash). My understanding of this is rudimentary, but since Treasuries are collateral that is viewed as information-insensitive, they will be hurt in the move back into risk assets that QE engendered.
    In any case, I look forward to reading your paper in more detail, and especially your justification for suggesting that QE increased Treasury bond prices as well as other asset prices.

  12. don

    ppcm: “Economic balancing is not supportive of a euro break up. The capital markets have more to fear from the computer hardware and the software programmers, than from the mere existence of any currency symbol on a Bloomberg clavier.”
    My view – Spain, Greece and Portugal will need to undergo some severe and prolonged unemployment and deflationary pressures to stay in the euro with Germany. Ireland as well. Ireland may stay the course, but I’m betting the others won’t.
    You have Mundell on your side and I have Feldstein on mine. I am betting (with real money) that I’m right. I hope you are not.
    This will take some time, but eventually we’ll see who is right.

  13. indio007

    It seems no one is looking at the main method the FED uses to create new money … real estate. The courts are clogged . MERS broke the system and clouded 60+ million mortgage titles.
    How to remonetize the economy in 3 steps.
    1. foreclose
    2. sell
    3. loan funds to buyer from monetized promissory note.
    Step one isn’t happening fast enough and the money supply is shrinking.
    The FED is monetizing anything that isn’t tacked down , the problem is the member banks don’t have acceptable collateral to pledge because it’s all tied up as loan loss reserve.
    That’s what they get for creating a secret circulating currency composed of individual issuer promissory notes for the purpose of tax evasion.

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