30 September 2011: SH: Can Operation Twist kickstart the US economy?

– The Fed’s actions have placed the US dollar in a better standing when compared with other developed market currencies, which should put downward pressure on commodity prices.
– Unfortunately, the Federal Reserve actions do not provide a green light for investing. In the meantime it is best to remain patient.

The Federal Reserve has once again implemented non-traditional measures in an attempt to restore confidence and boost a softening US and global economy. The Fed initiative – dubbed “Operation Twist” – will result in an immunised purchase of $400 billion of long-maturity treasuries over the course of nine months. We have often questioned the impact such a program would have on the economy and risk markets, as the purpose of the initiative was unclear.

Unlike in 2010, when the objectives were fairly straight-forward, the Fed’s action appears motivated by a desire to not disappoint fragile risk markets. While an immunised balance sheet was clearly less stimulative than many investors had hoped (US equity prices down 5%), building consensus on this relatively innocuous initiative was not easy. Indeed, three voting members of the FOMC dissented against Operation Twist. While on the surface this did not prevent the committee from moving forward with the policy action, it does raise questions as to how aggressive the Fed can be going forward if conditions warrant further action.

Terms of the deal

The Fed committed to purchasing longer-maturity treasuries (6-years to 30-years) through actively selling its current short-dated holdings (those maturing between three months and three years). Details of the upcoming program were simultaneously released with the FOMC minutes by the NY Federal Reserve (manager of the System Open Market Account). The size of the program was broadly in-line with market expectations; however, the commitment to the very long end of the Treasury yield curve was surprising. 29% of the $400 billion purchases will be made in the 30-year part of the curve. This will effectively remove all 30-year bond issuance over the next nine months.

The bulk of the remaining purchases will consume 50% of the 7-year issuance and two-thirds of the 10-year issuance during that time frame. In addition, the Fed committed to reinvesting principal and interest from its Agency mortgage and debenture portfolios back into the Agency mortgage market, in a move which surpassed market expectations. The reinvestment policy is fairly broad-based and is targeted at newly issued fixed rate Agency mortgages from Fannie Mae, Freddie Mac and Ginnie Mae. In total, the Fed has committed to removing a substantial amount of duration dollars (larger than QE2) from the investable universe over the next nine months.

Impact on Treasury market

There has been a substantial flattening of the Treasury yield curve (the 5-30s curve has flattened 35 bps over the week) and prices have risen as much as 1-5% in those securities targeted by the program. Maturities longer than 5 years have been the beneficiaries of the announcement with the 30-year bonds being the best performers.

The Treasury curve could remain well bid for quite some time as the supply/demand dynamics have changed favourably. While an outright sale of $400 billion 3-year and under Treasury notes should be a negative, there is substantial demand for short-end securities which has yet to be satiated.
Three month Treasury bills have been trading around 0.0% and have occasionally dipped into negative territory. We do not anticipate any substantial increase in short-term rates. The action by the Fed did not increase the size of the balance sheet so, at the margin, did not create incremental inflation concerns. On the contrary, inflation expectations have been falling dramatically and TIPS have lagged nominal yields in the market rally.

The Treasury curve itself is reaching the fair value level associated with the new supply demand adjustment. Incremental support for the Treasury market will likely reflect the developments in Europe and the behaviour of risk assets. We have just recently undergone a period of accelerated risk reversal. While it is possible for this trend to continue and remain supportive of treasuries, the market would likely require more negative catalysts to drive yields lower. The bulk of the price action last week surrounding the announcement of Operation Twist is the result of position adjustments as the market needed to rebalance after the details of the program were more favourable.

Impact on the economy

This recent action is beneficial (albeit modestly) to the economy, although it still remains to be seen what unintended consequences develop out of the flatter yield curve environment.

We have maintained for a while that the impact from further monetary policy would be limited. In fact, the major thrusts received in 2009 and 2010 were the result of coordinated monetary and fiscal policy. The recent action by the Fed is an immunised balance sheet manoeuvre. It does not increase the money supply nor should it increase inflation expectations further. So, to that extent, the actions by the Fed have placed the US dollar in a better standing (or at least a less unfavourable standing) when compared with other developed market currencies, which should put downward pressure on commodity prices. While the recent dollar strength may prove short-lived and the fact that there are other (and perhaps more prevailing) factors causing energy prices to fall, the immunizing action by the Fed reduces the speculative investing in energy that was experienced after QE2 last year.

To the extent that already-low yields were still prohibitive for corporations to expand capacity, this should create an additional incentive. There is some concern that the flatter yield curve will discourage banks from lending as ultra low yields in absolute terms (tightening of net interest margin) may not be sufficient enough for the volatility associated with the economic fundamentals.
The potential to reduce mortgage rates further (through mortgage reinvestments), should marginally improve the current housing market. But once again it is not a panacea. Rates are already low, and the difficulty for most remaining homeowners who did not refinance already, relates to negative equity and credit worthiness in a new housing environment.

Economic growth in the US remains particularly sluggish. Growth in Q3 appears to be a tepid but improved (from H1 ’11) 1-2% pace. The deceleration of activity through the current quarter is concerning and certainly places momentum heading into Q4 at a disadvantage. At the current time it appears unlikely that the US economy will slip into recession. However, the risks have risen. Gridlock in Washington risks a substantial tightening of fiscal policy in 2012, and the issues in Europe continue to add uncertainty to an already challenged business environment.

The Fed’s remaining options

There have been several other options we and other market participants have mentioned as potential non-traditional tools for the Fed to employ should the economy continue to stumble. Two are focused around an immunised balance sheet approach: Interest on excess reserves (IOER) and swapping current Treasury holdings for riskier assets.

IOER has the potential to be very disruptive to funding markets, money market funds and bank deposit accounts. The second option appears less compelling at this point. The fact that the Fed committed to reinvest mortgage principal back into the mortgage market appears to be as far as they are willing to tread into non-Treasury markets. There are also legal questions surrounding the ability of the Fed to venture into other assets. The final option that the Fed always has is its ability to expand the balance sheet, increase the money supply and purchase more treasuries. The current zero interest rate policy is treading dangerously on a liquidity trap environment which makes monetary policy less effective. The Fed, and Chairman Bernanke in particular, have stated the limited scope of monetary policy and that the responsibility must fall on the fiscal side to appropriately stimulate short-term activity without sacrificing long-term fiscal sustainability. To date, partisanship and posturing ahead of the 2012 election has prevented any meaningful conversation on the fiscal side to come together.

Our response

As our analysis suggests, the impact from Operation Twist is likely to have limited impact outside of the Treasury and MBS market. It is prudent to reduce exposure to 30-year treasuries because the size of the purchase program in that maturity bucket is simply enormous. The supply/demand technicals support a flatter curve, particularly in the 30-year maturity bucket. We believe investors should be watching for signals from policymakers that reduce uncertainty and provide a back drop that is more conducive for risk assets. Unfortunately, the Federal Reserve actions do not provide a green light for investing. In the meantime it is best to remain patient. Risk assets have been under a relentless bout of selling pressure over the last two months, so a reflective bounce would not be uncharacteristic. However, without confidence that the ongoing global problems will ease, bouts of stability in the market will likely be a period to reduce risk further.