It's official: Operation Twist will officially become QE4 at the end of this year. This shouldn't be a surprise. In fact, it would be somewhat naive to call this "news". Recall that sometime around the beginning of April, Bank of America noted that Operation Twist's days were numbered:
"... extending Twist is a limited option, as the Fed will have only about $175 bn of short-dated Treasuries (3 months to 3 years) in its SOMA portfolio on June 30."
While instructive, this really wasn't some kind of revelation based on top secret information. Twist had an expiration date stamped on it like a gallon of milk. All one had to do to determine the approximate date of the program's demise was log on to the New York Fed's website, go to the page which shows the System Open Market Account Holdings, and grab the nearest calculator.
As it became increasingly clear that fiscal policymakers would delay an earnest discussion of the fiscal cliff until after the election, the idea that the Fed might not continue to purchase $45 billion in long-term Treasury bonds per month past the expiration of Operation Twist became a virtual impossibility. It has been known then, for quite some time, that come December's FOMC meeting, the Fed would be forced to commit to a continuation of its monthly purchases of government debt only without the offsetting (sterilizing) sale of an equivalent amount of 3-month to 3-year paper.
To do otherwise would be to pull the QE rug out from under the market by taking some of the pressure off long-term interest rates which, in turn, would send conflicting signals (so you guys are going to buy MBS but not Treasuries?) and perhaps even start the whole charade to unraveling years ahead of even the most misanthropic forecasters' projected doomsday dates.
Consistent with this analysis, the Fed announced Wednesday what is effectively, QE4:
"The Committee ... will purchase longer-term Treasury securities after its program to extend the average maturity of its holdings of Treasury securities is completed at the end of the year, initially at a pace of $45 billion per month."
Blame it on the fact that the Fed's move was so widely anticipated. Better yet, blame it on the distinct possibility that, true to the commonplace analogy between quantitative easing and an addictive drug, equities now get virtually no high from successive iterations of what used to be a "nonstandard" policy. Whatever you blame it on, take note of the fact that this time around, the market's reaction to the promise of additional asset purchases was actually negative -- after the announcement, the market erased the morning's gains and closed flat.
In fact, Wednesday marked a historic break from post-crisis precedent in terms of the performance of stocks, bonds, and volatility. For the first time in the nonstandard policy era, the S&P 500 futures contract closed down on the day that a fresh round of asset purchases was announced. Similarly, the VIX closed higher Wednesday, marking the first time volatility has closed up on the day of a QE announcement. Perhaps most tellingly however, the yield on the 10-year Treasury bond closed higher on the day -- the first time yields have risen on an FOMC QE day:
Investors should ask themselves what it says about the credibility of the Fed when long-term Treasury yields rise on a day when the FOMC makes the following statement about interest rates:
"Taken together, [our] actions should maintain downward pressure on longer-term interest rates."
The explanation for the move higher in Treasury yields is tied up with the one surprise contained in Wednesday's FOMC announcement. For the first time, the Fed dovetailed (pun intended) monetary policy and what Bloomberg described as "hard, numerical targets." In other words, the course of monetary policy will now hinge on specific economic data points:
"... the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored."
This focus on specific, quantifiable thresholds has been affectionately dubbed "The Evans Rule" after Chicago Fed President Charles Evans. Perhaps it's good that the FOMC now has a "rule" in which to find recourse given that perhaps the most well-known rule for setting policy rates, the Taylor Rule, appears to prescribe a Fed Funds rate far from zero for the years ahead:
In any case, the Fed's specific mention of 6.5% unemployment and a specific threshold for inflation presents a problem: what happens if these thresholds are breached before the Fed's previous guidance regarding when interest rates will begin to rise? From the Wall Street Journal:
"This prompted bond investors to try to calculate if these new parameters meant the Fed will increase the policy rate sooner or later than the mid-2015 timing. This resulted in some concerns that the central bank would have to start tightening policy earlier than anticipated."
In fact, it would seem that the paradox some commentators posited last summer regarding bad economic data being good news because it leaves the door open for more easing, now has a firm basis in reality. It would now be a terrible turn of events in terms of bond market stability if the unemployment rate were to suddenly plummet. As ZeroHedge noted Wednesday,
"... starting [Wednesday], every incremental economic data point that is materially better, brings us closer to an explicit end of Fed intervention. As the economy continues along an "improving" glideslope, whether real, manufactured or doctored, the market will start pricing in its own "flow"-based demise."
Investors have a difficult decision to make. If you believe the economy is likely to improve markedly in the very near future, you also believe (even if you didn't realize it) that the bond market bubble could be closer to popping that previously imagined. As one fixed income strategist quoted by the Journal noted,
"... given the employment number has come down by 0.6 in the last four months, it could be at 6.5% within eight months or by the end of summer. The market is not priced for this scenario, not even close." (emphasis mine)
The following graphic illustrates this point by showing when, based on Bureau of Labor Statistics' projections, the 6.5% threshold will be crossed:
Source: ZeroHedge, BLS
Take heed: up is now officially down. Welcome to the world of Fed engineered paradoxes. In my opinion, Wednesday's announcement of specific threshold targeting provides further evidence for the claim that the bond market rally (now some 3 decades long in the tooth) is on the verge of an rather epic unwind. Recommendation (made here with a renewed sense of vigor): short U.S. Treasury bonds.