Abstract
In the context of a state-space model for nominal and TIPS yields, we identify the liquidity premium in the TIPS market as the common component in TIPS yields that is unspanned by nominal yields. Using daily US yields, we find that the TIPS liquidity premium explains up to 22% of the variation in TIPS yields and that it sharply spiked during the 2008 financial crisis. We also find evidence of a flight to liquidity effect in the US Treasury market, as yields on nominal bonds decrease following a shock to the liquidity premium in the TIPS market. In addition, a counterfactual exercise shows that the QE2 programme had only limited effect on the liquidity premium in the TIPS market.
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