Lower yields through open market operations
When the fed wants to put downward pressure on treasury rates, one tool it can use is open market purchases of the tenor it wants to push yields down on. Mechanically, I assume this can be achieved 2 ways:
- open market purchases in the secondary market (previously auctioned securities)
- purchases at auction with primary dealers acting as an intermediary.
Option 1 it's clear how the yields would be affected. The fed just places bids at a price sufficient to hit the yield it is targeting, and since that is likely above the prevailing market price, it will be accepted. Similar bonds will then price up to reflect this price action. New auctions will not price higher (yield less than) these off-the-run issues in a meaningful way, otherwise market participants would just buy the off-the-runs.
Option 2 is less clear to me. Treasury auctions are "single-price", meaning that everybody submits their minimum accepted yield, and the highest accepted yield (the "stop") is what all participants receive1. Here, if demand is strong and the primary dealer doesn't take down the entire auction, what would happen when other participants bid higher than the dealers? Could that neutralize their efforts to suppress yields? For example, let's say the auction is for $500B of 10 year notes, and the following bids are received:
1 The Treasury Auction Process
|bidder||bid yield||bid size||accepted size|
|Hedge Fund 1||3.20%||100B||100B|
|Hedge Fund 2||3.28%||150B||150B|
|Hedge Fund 3**||3.33%||75B||50B|
|Money Market Fund||3.45%||100B||0B|
*Fed, using primary dealer as intermediary
**Hedge Fund 3 is the "stop yield" bid
The fed (through primary dealer) wants yields at 3.00%, but they only bid 200 of the full 500 issuance. Hedge Fund 3 has the highest bid (the "stop") so the entire auction prices at 3.33%. How is this issue avoided in practice? Does the dealer just take the whole bid down? Does the treasury simply refuse bids below a certain yield (which would mean they are working with the fed)? Are purchases at auction not really a tool used to push yields lower (only secondary market purchases)?
Increasing yields through open market operations
Going in the other direction, it would appear the fed has less control. There is nothing to be done at auction other than not participate, so the primary tool to raise yields would reducing their SOMA portfolio, which can be accomplished two ways:
- Not reinvesting maturities (what is currently happening)
- Selling SOMA holdings outright in the secondary market
Option 1 not reinvesting maturities removes reserves from the private sector as new issuances by the treasury must be met by non-fed institutions. If cash is limited enough, they will probably demand a higher yield for treasuries. This seems more of a blunt tool, as it would be hard to target a tenor (depends on what the treasury issues) and similarly difficult to know how much reserve withdraw equates to how much rate increase, and where on the curve that increase occurs. If demand for treasuries is particularly strong, I would assume it may be possible that, even flooding the market with new issuances, yields remain stubbornly low.
Option 2 - would provide more precise control, as the fed could place an ask price at the yield it wants to target (and for the tenor), and if that yield is above market participants will take it. Even if there is strong demand there is no chance of yields remaining below what the fed desires (like in the auction example) because the fed just keeps selling at prices below market until it's desired yield is achieved.
So my general questions - are the assumptions I've made above correct for the 4 options (2 lowering yield, 2 increasing)? For auction purchases, is the bidding conundrum I outlined an issue?