Scarcity and Spotlight Effects on Liquidity: Quantitative Easing in Japan

We investigate the determinants of the term structures of bond yield and market liquidity in the case of the Quantitative Easing (QE) programs implemented by the Bank of Japan (BoJ). We distinguish between two opposing effects of QE on the liquidity and the yield of Japanese Government Bonds, the “scarcity effect,” which is gradually manifested as a negative impact on liquidity, due to the shrinkage in the available supply of bonds; and the “spotlight effect,” which induces an immediate improvement in liquidity, reflecting BOJ’s massive demand. Between 2011 and 2016, we find that government bonds show an improvement in liquidity through the spotlight effect, but also experience a deterioration in liquidity through the scarcity effect. As for the yield, both the spotlight and scarcity effects work in the same direction (i.e., they raise bond prices). Illiquidity caused by scarcity amplifies the yield decline rather than adding to the illiquidity premium.