The effects of the interest rates on the government bond liquidity

Abstract

Understanding the impact of interest rates on the government bond market is crucial, given that interest rates have traditionally been the primary instrument of monetary policy for central banks. While extensive research has been conducted on the determinants of government bond liquidity, the influence of interest rates during the quantitative easing using Wu-Xia shadow rate remains relatively underexplored. Purpose of this thesis is to study the effects of interest rates on government bond liquidity. To conduct this study, 10-year benchmark government bonds from Finland, Italy and the US will be used. Interest rates will be studied by using Federal Funds Rate, the ECB key rate and Wu-Xia shadow rate to be able to capture the effects of the quantitative easing and the unusually low interest rates. Liquidity is examined by bid – ask spread and the data used are from September 2005 to December 2022. The timeline covers European debt crisis, Covid-19 outbreak, negative interest rates, and various inflation levels.

The results indicate that the changes in the ECB key rate or Wu-Xia euro area shadow rate do not affect the liquidity of Finnish or Italian 10-year government bonds. Shock to the federal funds rate has positive and persistent effect on the US government bond liquidity. On the other hand, results indicate that shock to Wu-Xia US shadow rate has negative and persistent effect on the liquidity of the US government bonds. This is most likely due to Wu-Xia shadow rate’s ability to go below zero. Fed decreasing market operations during negative interest rates leads to increase in Wu-Xia shadow rate while reducing the liquidity.

Understanding how changes in interest rates affect government bond liquidity is crucial for policymakers, governments, investors, and financial institutions, as it can provide insights into market dynamics, risk management strategies, and the effectiveness of monetary policy measures.