The impact of QE on sovereign bond liquidity

Previous literature has found different results regarding the effect of quantitative easing on sovereign bond liquidity. QE was introduced after the 2008 financial crisis to revive the economy and financial markets in a deflating economy, but growing literature on the topic has raised concerns about QE's harmful consequences on the bond market. The ECB has increased its balance sheet rapidly even in economically stable times, reducing the bond stock in the market. Empirical evidence suggest that QE can both increase and decrease bond liquidity, depending on which of the transmission channels of QE – scarcity or spotlight effect – is considered. This thesis investigates the relationship between Eurozone 10- and 30-year government bond bid-ask spreads and the ECB’s asset purchases during the PSPP programme and Covid-19 period. The thesis' main goal is to investigate whether the net asset purchases of public assets increase bond liquidity via the spotlight effect and whether the cumulative net asset purchases reduce bond liquidity via the scarcity effect. The study is motivated by the importance of government bond liquidity, which must be maintained in order for governments to maintain effective capital allocation and lower borrowing costs. This thesis contributes to the existing literature by offering the first regression results for the Covid-19 period that have not previously been investigated in terms of the influence of QE on government bond liquidity in Europe. To address the thesis' four hypotheses, linear and panel regression models are used. The thesis employs monthly asset purchase and bid-ask spread data from 3/2015 to 10/2022 and 6/2020 to 10/2022. A Purchase variable is introduced to explain the net asset purchases, and a Holding variable is introduced to explain the ECB's balance sheet expansion. The liquidity is measured using 10- and 30-year maturity bid-ask spreads. The PSPP programme and the Covid-19 period, which includes both PSPP and PEPP purchases, are evaluated separately for each of the nine selected countries, as are the two bond maturities. To examine the differences between the periods and maturities, panel regression analysis is used. Control variables are also introduced to the models to verify the robustness of the results. This thesis gives valid results for the pandemic period that contradict previous research. Different outcomes are obtained for the PSPP programme and the Covid-19 phase. According to the regression results, the spotlight effect of QE occurs in many European bond markets throughout the Covid-19 period, enhancing liquidity, but the scarcity effect does not appear. In turn, the PSPP programme, which ran from 2015 to 2022, primarily decreases liquidity in the bond markets via the spotlight and scarcity effects of QE. One probable explanation for the disparity between Covid-19 and PSPP findings is the severe impact of Covid-19 on the financial market, which stretched from the stock market to the bond market. Bond liquidity has already been damaged by Covid-19, which explains why QE has less of an impact during this period.