How the fed influences treasury rates through open market operations

Question

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
primary dealer*	3.00%	200B	200B
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?

Answer 1

For Option 1 (lowering yield) the procedure is not described correctly in the OP. The Fed does not place bids in the market. In fact, they ask primary dealers for their offer price for a range of different securities, entered on the Fed website at around 10am on specific dates. They then use an algorithm to decide which prices to accept, publishing the results promptly. The details can be found on Fed https://www.newyorkfed.org/markets/domestic-market-operations/monetary-policy-implementation/treasury-securities/treasury-securities-operational-details

Lowering yields Option 2 is incorrectly described. The Fed does not bid competitively at Treasury auctions. Instead, they purchase securities at the auction yield determined by the private market participants. One could still argue that their activity drives yields down, because it reduces the amount of securities that are being sold to the public. Note also that the Fed is not allowed to increase their portfolio size using Treasury auctions. They are only allowed to roll over maturing securities. Details: https://www.newyorkfed.org/markets/treasury-rollover-faq

For raising yields, Option 1 is described almost correctly. The Fed sets a monthly principal amount of Treasury face value that it allows to mature without reinvestment. Let’s say it is 80bn for a given month. But if 100bn of securities mature that month, 20bn will be reinvested, giving the Fed some control over maturity buckets.

Raising yields Option 2 has never been implemented. Theoretically it could be, but so far the Fed has chosen the more passive route of allowing securities to mature.