Government Intervention and Strategic Trading in the U.S. Treasury Market

Abstract

We study the impact of outright (i.e., permanent) Open Market Operations (POMOs) by the Federal Reserve Bank of New York (FRBNY) on the microstructure of the secondary U.S. Treasury market. POMOs are trades in U.S. Treasury securities aimed at accomplishing the Federal Reserve’s target level of the federal funds rate. Our analysis is motivated by a parsimonious model of speculative trading in the presence of a stylized Central Bank targeting the price of the traded asset. Contrary to previous studies of government intervention in financial markets, we show that such trading activity improves equilibrium market liquidity, and that the magnitude of this effect is sensitive to the market’s information environment. We test these implications by analyzing a novel sample of intraday U.S. Treasury bond price quotes (from BrokerTec) and a proprietary dataset of all POMOs conducted by the FRBNY between 2001 and 2007. Our evidence suggests that i) bid-ask spreads of on-the-run Treasury securities decline on days when POMOs are executed; and ii) POMOs’ positive liquidity externalities are increasing in proxies for information heterogeneity among speculators, fundamental volatility, and policy uncertainty, consistent with our model.