Asset Purchase Rules: How QE Transformed the Bond Market

We argue that quantitative easing (QE) and tightening policies constitute a dynamic state-contingent plan instead of a succession of independent interventions. This view changes the main reason QE is effective by adding an insurance channel to the static effect of absorbing bond supply in a given period. QE purchases occur in bad economic states (e.g., 2008-2009 or 2020) when the supply of government debt increases. Increasing long-term bond prices in bad economic states increases their safety, driving up their value and thus lowering ex-ante yields. We estimate that this insurance channel alone lowers long-term bond yields by 75-100 bps. This channel explains the prevalence of low long-term yields, low term premia, and low
yield volatility since the introduction of QE, despite the sharp increase in net government debt supply. Consistent with a state-contingent channel, implied volatilities of long-duration risk-free securities fall substantially on QE announcements, even for options with maturities out to 10 years. We calibrate a policy rule for asset purchases to their historical path and include it in a quantitative term structure model. In the model, state-contingent QE offsets term premia fluctuations in long-term bonds. The insurance effect from this channel lowers long-term Treasury yields by 75bps ex-ante, which explains about 75% of the total effect of QE on yields. The calibrated model matches both broad patterns in bond yields and the response to QE announcements.
With Valentin Haddad, Alan Moreira, and Tyler Muir