RDP 2022-02: The Yield and Market Function Effects of the Reserve Bank of Australia's Bond Purchases 2. How Bond Purchases Work, and the International Experience

Central bank purchases of longer-term government bonds can lower bond yields via a number of channels including:

• portfolio rebalancing – the accumulation of government bonds by the central bank bids up their price as other assets are only imperfect substitutes, removes interest rate risk from the market, reduces term premia, and induces investors to buy other assets, including to replace the bonds that they sold;^[5]
• signalling – bond purchases underline the commitment of the central bank to hold policy rates lower for longer (including because policy rates are unlikely to be raised while bond purchases are ongoing) and so reinforce expectations for a low policy rate;^[6] and
• reducing liquidity premia – steady central bank buying reduces the risk of investors being unable to sell bonds at a reasonable price, and increases commercial banks' reserve balances.^[7]

The portfolio rebalancing and signalling channels operate in the main via an announcement effect; that is, they cause bond yields to change when bond purchases are announced, rather than when purchases are actually made. For the signalling channel, this is because – assuming the central bank's commitment is credible – signals are delivered with the initial announcement of the program, or subsequent announcements relevant to the total amounts of bonds to be purchased and/or the holding period for those bonds. For the portfolio rebalancing channel, this follows from the fact that market participants are forward-looking, and so will anticipate and trade on the expected effect of future rebalancing flows immediately, as discussed above. Conversely, if the purchase announcement is not perfectly credible, some of the signalling and portfolio rebalancing effect may be delayed until the announcement is actually delivered upon and purchases (and other actions such as reinvestments) are undertaken. The liquidity premia channel relates to the ability to sell bonds in the market without adversely moving yields, and so, to the extent that this is significant, it will have a larger implementation component associated with actual bond purchases as and when they are made (this is especially the case in government bond markets, when liquidity premia are likely to be elevated only in stress conditions). There is no consensus about the relative importance of each channel, but it is generally accepted that the liquidity premia channel is most important during periods of market stress – for example, in March 2020 and the months following – whereas in more normal times, when government bond markets are liquid and well-functioning, liquidity premia are already low and that channel is less important.

The empirical literature on bond purchases, based on experiences in other countries, suggests that at the initial purchase program announcement each 1 per cent of GDP worth of purchases sees yields decline by around 5–7 basis points on average, although the range of estimates is wide.^[8] Initial bond purchase programs also tend to have larger apparent effects than the announcement of subsequent programs or extensions of the initial program. This is because additional rounds of bond purchases are often expected by markets and so are at least partially priced in already at the initial announcement of a program, and it is difficult to disentangle these pre-existing expectations from the new information in an announcement of a program extension. Also, many early bond purchase programs were initiated during a period of market stress, when the liquidity premia channel of bond purchases was relatively important, whereas subsequent programs were often implemented in more settled markets when liquidity premia were low. Of note, government bond markets were stable and well-functioning in November 2020 when the Reserve Bank commenced its bond purchase program, whereas this was not the case in early 2020 when the Reserve Bank was purchasing government bonds to restore market function.

The $100 billion of bond purchases announced by the Reserve Bank under the bond purchase program on 3 November 2020 was equivalent to around 5 per cent of nominal GDP in Australia, and so applying the international experience to Australia would suggest a reduction in longer-term yields of around 25–35 basis points. Further, most of the effect would have been expected to have come via the portfolio rebalancing channel lowering term premia: liquidity premia were already low and, while bond purchases would have had some signalling effect, forward guidance and the 3-year yield target were already providing a powerful signal regarding future policy.

Footnotes

Portfolio rebalancing flows will tend to be strongest for assets that are most similar to those purchased, and be weaker for assets that are less similar (Krishnamurthy and Vissing-Jorgensen 2012). For example, if the central bank wishes to purchase a large volume of 10-year government bonds, it will need to induce those currently holding those bonds, and who may highly value their liquidity and safety, for example, to sell and purchase other assets instead. A small fall in the yield of 10-year government bonds relative to other very similar assets (e.g. 9- or 11-year government bonds) may be enough to induce investors to rebalance their portfolios to such substitutable assets, thereby spreading the price impact of central bank buying to those assets. Conversely, government bond yields are likely to have to fall more significantly in order to induce an investor to instead buy corporate bonds, or equities, which have quite different characteristics to government bonds. See also Li and Wei (2013), Gorodnichenko and Ray (2017) and Vayanos and Vila (2021) for models in which preferred habitats play an important role in the portfolio rebalancing channel. [5]

See also Schnabel (2021) and the references therein for a discussion of how the signalling channel might operate. [6]

See also Christensen and Krogstrup (2019) for a discussion of the role of central bank reserves. [7]

See, for example, Gagnon (2016), CGFS (2019), Bailey et al (2020) and Bank of England's Independent Evaluation Office (2021) for review papers. [8]