Introduction of Operation Twist
The Federal Open Market Committee concluded its September 21, 2011 Meeting at about 2:15PM EDT by announcing the implementation of Operation Twist.
This is a plan to purchase $400 billion of bonds with maturities of 6 to 30 years and selling bonds with maturities less than 3 years, thereby extending the average maturity.
This is an attempt to do what Quantitative Easing (QE) tries to do, without printing more money and expanding the Fed's balance sheet and therefore avoid the inflationary pressure that QE brings. This announcement brought a bout of risk aversion seen in the equity markets, and strengthened the US Dollar, whereas QE II had weakened the USD and supported the equity markets.
The Federal Open Market Committee action known as Operation Twist (named for the Twist dance craze of the time – from a song by Chubby Checker (pictured)) began in 1961.
The intent of Operation Twist “was to flatten the yield curve in order to promote capital inflows and strengthen the dollar. The Fed utilized open market operations to shorten the maturity of public debt in the open market.
It performs the 'twist' by selling some of the short term debt (with three years or less to maturity) it purchased as part of the quantitative easing policy back into the market and using the money received from this to buy longer term government debt.
Although this action was marginally successful in reducing the spread between long-term maturities and short-term maturities, some economists have suggested it did not continue for a sufficient period of time to be effective. Despite being considered a failure in near-term analyses, the action has subsequently been reexamined in isolation and certain economists have suggested it was more effective than originally thought.
One recent study found that it drove down the interest rate on Treasury bonds by 0.15 percentage points. But the effect on mortgage rates was smaller, and the effect on corporate borrowing costs was tiny.
However, as a result of this reappraisal, similar action was suggested as an alternative to quantitative easing by central banks.
For a fairly in-depth look at the history of Operation Twist …..click here
Will Operation Twist Work?
Easing monetary policy in this new and different way has much the same effect as QE1 and QE2, but quiets many of the critics who were worried that by printing money, the Fed will spark inflation. Also, when the public hears about billions of dollars of quantitative easing, too often they misinterpret this as dollars building bridges we don’t need. QE1 and QE2 didn’t do that. But Operation Twist is clearer still: The Fed is just swapping one set of bonds for another.
There are two levels at which we talk about these things working:
A. Will the Fed succeed at reducing long-term interest rates? They already have. Despite the fact that Operation Twist was largely anticipated, this boost was larger than most expected. And so in the minutes after the announcement, the 30-year Treasury fell by 13 basis points. That might not sound like a lot (one-eighth of a percentage point), but its one-eighth off, for 30 years! Those are some big savings. Also, it’s worth comparing this with how much of a conventional reduction in short-term interest rates would be required to get the 30-year Treasury to fall this far. The answer is: Quite a lot!
B. Will Operation Twist stimulate the economy? Answer: It won’t hurt. The economy certainly needs all the help it can get right now. This is a step in the right direction. I think that an economy this unhealthy needs even more medicine. It is extremely good that the Fed took this step. Miracles may not occur, but it will help.
Effect on the Stock Market
The stock market's skeptical reaction reflected the limited outlook for the program's impact. If the Fed's move spurs the economy, investors could see their portfolios climb. But the initial response of investors was a sell-off Wednesday and Thursday, partly because of the Fed's suggestion that the economic slump could last for years.
Prospects for sustained improvement are still significantly hindered by the shaky job and housing markets as well as Europe's spreading debt crisis.
How consumers may be affected in various financial categories from Operation Twist:
Mortgage rates are a focus of the new plan. The Fed intends to sell $400 billion of its shorter-term Treasurys to buy longer-term Treasurys by June 2012. And it will reinvest principal payments from its mortgage-backed securities to help keep mortgage rates ultra-low.
These steps alone won't spur a housing boom.
Interest rates already are at the lowest level in six decades, averaging 4.09% on a 30-year fixed mortgage and 3.29% on a 15-year fixed.
Prospective homebuyers aren't putting off home purchases because rates are too high. They're holding off because they're lacking confidence. They're worried about a recession or job loss and are unwilling to take on more debt, even at lower rates, or aren't able to qualify. Others see no reason to jump into the housing market when prices are still falling.
Still, the Fed hopes to at least stimulate more refinancing activity as a way to get the economy moving.
Most credit cards have variable rates that are tied to the prime rate. So consumers can still take some comfort in the Fed's August pledge that it plans to keep interest rates very low until at least mid-2013, assuming the economy remained weak; the prime rate has historically tracked the federal funds rate.
But credit card rates won't get any lower because of the Operation Twist, according to McBride. And if it fails to improve the limping economy, they could even rise.
That's because the prime rate and federal funds rate don't necessarily move in lockstep with each other. The prime rate reflects the actual rates at which banks are lending to each other and is determined by the market. So even if the Fed fails to raise rates, the prime rate could rise if banks became skittish about lending to each other.
Similarly, the rates on car loans are expected to be unaffected. From the consumer standpoint, borrowers will benefit only from better rates on longer-term loans: fixed-rate mortgages, fixed-rate home equity loans and, for entrepreneurs, fixed-rate small business loans.
Savers who have been earning next to nothing on their money may see slight improvements.
Operation Twist should push up short-term interest rates for money-market accounts "from next to zero to something that isn't quite as bad," says James Angel, associate professor of finance at Georgetown University's McDonough School of Business.
But that's not assured.
The Fed's reshuffling of debt may well have the unintended consequence of making it harder for banks to make money from lending, McBride says. If that happens, they'll be less willing to pay as much on consumer deposits.
By buying long-term Treasurys, the Fed aims to drive the rate of those securities down. That means investors in long-term bond funds who sought to play it safe and pocket reliable income could see less of it.
"If you're a retiree who was relying on interest income, this could prove to be a negative depending on where you're invested," says Don Rissmiller, chief economist of Strategas Research Partners.
Another potential negative, derived from Operation Twist, is that the cost of insurance could rise. Lower rates would be bad news for insurance companies, particularly life insurers. That's because they hold much of their investment portfolios in long-term bonds. If their investment returns drop they could compensate by charging consumers more, says David Nanigian, assistant professor of investments at The American College in Bryn Mawr, Pa.
But neither of these impacts should be drastic. Long-term interest rates aren't expected to come down more than 0.2% in the wake of the Fed action.
Analysts say Operation Twist could raise stock prices by boosting confidence and helping borrowers and savers.
But Fed Chairman Ben Bernanke can only dream of providing the stock market with anything close to the 28% rally that took place over seven months following the announcement last fall about the second round of quantitative easing, or QE2 — a $600 billion program to buy government bonds.
Even if stocks head upward for now, Joseph LaVorgna, chief U.S. economist at Deutsche Bank, doesn't see anything for investors to cheer in the Fed's actions.
"As long as the events in Europe are continuing to play out, that's going to keep a lid on equities," he says. "These actions won't do much other than cause people to say, 'OK, what next?'"
Other Consequences of Operation Twist that may occur:
1. The Federal Reserve moves with all the surprise and guile of a lumbering elephant. It talks about moving, says what direction it might go in and at what speed, and provides a specific date on which it will act. It does so because it wants to avoid spooking the market. But it also means that the market tends to react well ahead of the actual event. Look at the path of the 10-year bond over the last several weeks. The interest rate on the 10-year bond has fallen from 3.2 percent on July 1 to about 1.9 percent today. The mere anticipation of the Fed's move, by introducing Operation Twist, has caused the market to do much of the Fed's work.
2. Given how low long-term interest rates already are -- they've fallen by 40 percent in the past three months -- that's all very good as these lower rates help free up more cash for some people to spend, help corporations pay their bottom line, and lessen the fiscal bite of high deficits, but when you get close to zero, it becomes harder to make a bigger percentage difference. Money simply can't get much cheaper.
3. The spreads between municipal or corporate bonds to Treasurys may widen. Yields on those could go down (where there isn’t growing risk of defaults as with many municipal bonds), but not as much as Treasurys will.
4. Bond speculators may be rewarded with capital gains.
5. The capital that goes to bond speculators comes out of the capital accounts of the bond issuers. It becomes a zero-sum game. When interest rates rise, bond speculators lose and bond issuers gain……when rates fall, the opposite occurs.
6. One of the banks’ (illicit) sources of risk-free profits is reduced. Yield curve arbitrage, borrowing short to lend long, will become less profitable.
7. Where bond issuers have access to the markets to “roll” their liabilities, the new payments should be lower. In theory this would allow them to borrow more (which is what the Fed intends). In practice, who knows! Certainly governments do, as there is little or no personal downside to the politicians who make such decisions.
8. Any borrowing that only makes sense because the interest rate was further reduced is, almost by definition, malinvestment. Such borrowings will not be paid back. Car buyers would do well to consider the total cost of ownership over the life of that 84-month 15% interest loan with the balloon at the end and “affordable” payments. The same is true with government and corporate borrowers: there are other considerations than monthly payment.
9. Assuming any business does borrow at the new, lower rate, it will have a permanent competitive advantage over its competitors who borrowed at the old, higher rate. The new borrower will either be able to produce the same good at lower cost (due to lower debt service) or be able to attract customers to the new restaurant, hotel, resort, cruise ship, shopping mall, etc. Customers love higher ceilings, lavish landscaping, opulent gilding dripping from the marble columns, etc.
10. Capital destruction is sure to continue and accelerate.
11. The process of halving of interest rates will continue. It is just as damaging to go from 1.5% to 0.75% as it was to go from 12% to 6%.
12. Debt accumulation will surely continue or heaven help us, until it cannot continue!
Future Moves by the Fed
The data for September is looking weak, and most people are now expecting growth over the next year or two to be insufficient to reduce unemployment by much (if at all). However, the Fed is more optimistic. They will probably see more weak data coming, and so will have to move to even more accommodating monetary policy..… another Operation Twist proposal....which is obviously going to be controversial as they are doing a dreadful job in explaining that what they are doing is much more like conventional monetary policy than they are letting on.
One policy suggestion right now comes from Chicago Fed President, Charlie Evans (pictured). He has suggested that the Fed announce that they are willing to tolerate higher inflation until the unemployment rate falls below some level.
Why not make it clear: We want unemployment to fall below 7%, and we aren’t going to fret if pursuing that goal causes inflation to temporarily rise to say, 4%? I know not everyone will like this, but the suffering caused by today’s unemployment is surely larger than that caused by a little inflation. Indeed, many economists believe that a little bit of inflation would help consumers work their way out of their current debt overhang.
For the last three years, even as it has made extraordinary efforts to keep money cheap, the Fed has also given banks incentive to sit tight. The central bank requires banks to keep a certain level of reserves on deposit at the Fed. Legislation passed in 2006 permitted the Fed to start paying interest on those reserves starting in 2011. The change was accelerated due to the financial crisis. In October 2008, the central bank announced it would pay interest on those reserves, as well as on reserves posted in excess of the requirements. The amount is small: .25 percent per year. But essentially the Fed provides banks with an incentive to husband resources more carefully. As this data series shows, banks now have $1.57 trillion in excess reserves parked at the Fed, up from $981 billion a year ago.
Imagine if the Fed stopped paying interest on those excess deposits -- or if it imposed a penalty on them. Bankers do respond to incentives. And if they had less incentive to lock cash up at the Fed, they might buy bonds, or get a little more aggressive about lending.
If the initiative succeeds in helping the economy regain momentum, Operation Twist may be as important for what consumers don't experience — another recession — as for what they do."The impact on consumers is pretty minimal," says Greg McBride, senior financial analyst at Bankrate.com.
Some put it more bluntly. For consumers, the new plan is "a big snore," says Glenn MacDonald, professor of economics and strategy at Washington University in St. Louis.
Nonetheless, some rates that affect consumers may see changes in the months ahead as a result of the decision by implementing Operation Twist.
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