The Term Structure of Liquidity Premium
48 Pages Posted: 7 Nov 2019 Last revised: 8 Mar 2020
Date Written: October 28, 2019
We analyze the term structure of Treasury liquidity premium (LP). Through a model where illiquidity shocks can be alleviated by holding money and Treasuries, we show that the LP term structure is determined by (i) expectation of future liquidity conditions, (ii) liquidity term premium, (iii) monetary policy and the substitutability between money and Treasurys, and (iv) Treasury supply. Consistent with the model, we find that short-term LP is higher than long-term LP in recessions and is lower in booms. Moreover, forward LP strongly predicts future short-term LP and future market liquidity. We also find that policy interest rate significantly affects short-term LP, but not long-term LP, suggesting that money has high substitutability with short-term Treasurys but little substitutability with long-term Treasuries. We use the LP term structure to infer Treasury safety premium (SP). We find that SP contributes to Treasury convenience yields similarly to LP across maturities, and long-term SP is higher than short-term SP.
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