How QE Changed the Shape of the U.S. Yield Curve.

• Author: Singh, Manmohan

Our work on "reverse" monetary policy transmission is the first analytic work on how transmission takes place from collateral in the market to short-term market rates (Singh and Goel 2019). The use of long-dated securities as collateral for short tenors--for example, in securities lending, derivatives, repo markets, and prime brokerage funding--also impacts the risk premia (or moneyness) along the yield curve. In this article, we show that transactions using long-dated collateral, post-Lehman (i.e., following the bankruptcy of Lehman Brothers on September 15, 2008), are fewer, and have adversely impacted the transmission to short-term market rates. Our results suggest that the unwind of central bank balance sheets will likely strengthen the monetary policy transmission.

Some Background

Historically, most monetary policy research tries to explain the term "premia" using the expected path of future short-term rates. This approach is in fine with the standard monetary policy transmission mechanism whereby central banks generally target a short-term rate. These short-tenn rates, combined with investors' preferences at different maturities of the yield curve (also called the "preferred habitat hypothesis") and fundamental economic factors, pass through to the long-term rates. This transmission channel has been researched extensively in the literature (e.g., Del Negro et al. 2017). We all have been taught that short-term policy rates drive the whole yield curve--specifically, that market expectations about the future path of the overnight federal funds rate are reflected in 10-year yields and beyond.

In recent years, drat transmission mechanism has broken down, with policy rate hikes not percolating to the long end of the yield curve. Since the Fed's lift-off in December 2015, from zero to 2.5 percent, the 10-year Treasury yield actually declined from 2.30 percent to around 2.0 percent (before the most recent rate cut(s) starting in July 2019, and now to zero on the back of COVID-19).

Less well understood is the reverse transmission mechanism, from long-term bonds to short-end rates. This happens as a result of the reuse of long-tenor bonds as collateral in repo, prime brokerage, derivatives, and securities lending markets. The use of longer-term bonds as collateral in money markets can change the effective supply and demand dynamics at the long end, which then feeds back into short-term rates. For instance, if there is a greater supply of long-term collateral available to pledge in the repo markets, money market funds will increase overnight lending and purchase fewer T-bills, causing short-term rates to rise. This is even more relevant in the postglobal financial crisis era, when the collateral market has declined sharply and the expected short-term rates were bolted near zero by quantitative easing (QE). As background, in the aftermath of QE or a variant thereof, expanded central bank balance sheets that silo sizable holdings of U.S. Treasuries, U.K. gilts, Japanese government bonds, German bunds, and other AAA (or somewhat lower) eurozone collateral have placed central bankers in the midst of market plumbing that determines the short-term rates. Given their sizable footprint in the market for such collateral, it will be very difficult for them to walk away from that role. Thus, this channel and the potential implications for the monetary policy transmission are critical to examine.

Our research shows that a $1 trillion change in pledged collateral can move short-term rates by as much as 20 basis points (bp). However, this reverse transmission mechanism has also broken down of late. The 2008 financial crisis led to a structural change in the collateral markets. The longer-term pledged collateral market grew to about $10 trillion pre-Lehman. Immediately after Lehman's bankruptcy, this market collapsed to about half its peak and remained unchanged until 2016. This decline was initially due to crisis-related haircuts and counterparty risk in dealers and was cemented by QE and regulatory changes.

Initially, QE lowered long-tenor spreads as central banks took duration risk out of the market. This also meant there were fewer long-tenor bonds to pledge in the collateral markets, which compressed short-term rates. Then, regulatory changes--such as the liquidity coverage ratio (LCR), which requires banks to maintain sufficient holdings of high-quality liquid assets (HQLAs) to cover stressed outflows--had a similar effect.

Research Intuition

In general, high quality bonds, when pledged with title transfer, are constantly reused in a process that is akin to the money creation that takes place when banks take deposits and make loans. For global banks that are active in the pledged collateral market, there are two primary sources that pledge collateral to the banking system: hedge funds and other financial intermediaries. In 2007, the collateral velocity (or reuse rate) was $10 trillion/$3.3 trillion, or about 3.O. (1) Collateral velocity has been lower in recent years, initially due to the Lehman crisis and elevated counterparty risk in global systematically important banks (GSIBs). In subsequent years, the reuse of collateral was constrained due to regulations that restrict dealer banks' balance sheet space (e.g., via the leverage ratio), and due to central banks' purchases of good collateral (under various QE programs). However, as of year-end 2018, the pledged collateral received by the major banks that could be repledged in their own name was around $8.1 trillion, an increase of 33 percent relative to year-end 2016, with...