Market expectations of a new monetary easing in the US are increasing with each passing day. The latest macroeconomic figures are worse than mediocre, and Bernanke's decision to convert the Fed board meeting initially set for September 21 into a two-day affair, September 21-22, has only heightened these expectations.
But despite the conventional wisdom, such action has already taken place in Europe and may indeed accelerate, as I will try to demonstrate later in today's report.
Operation Twist of 1961
First, it is important to review what was in fact Operation Twist, because many who use the expression today do not really understand the major differences between the situation today and that of 1961.
Operation Twist was launched by John F. Kennedy in early February 1961, less than two weeks after he was sworn in as America's 44th president. Initiated in conjunction with the Federal Reserve, the operation consisted of reducing the maturity of American government debt, with the US Treasury issuing 18-month T-Bills as the Fed bought -- for the first time ever -- long-term debt (i.e., with maturity of over 5 years). The aim was to flatten the yield curve and especially to reduce the yield on long-term bonds via bond purchases and issues of various maturities to stimulate a sagging American economy. Annual GDP growth had declined from +11% in Q2 1959 to +3.5% in Q2 1960 and +0.2% in Q1 1961. In short, Kennedy inherited a decelerating economy.
The Fed's goal in QE1 and QE2 was also to lower long-term interest rates (although the reality of the situation is a bit more complex than that, as we will show below) in order to help recharge investment (business financing plans) and consumption (home, auto loans, etc.).
The latest research on Operation Twist, like that of Alon & Swanson, published by the San Francisco Fed (Operation Twist and the Effect of Large-Scale Asset Purchases), estimate that it had 0.15% impact on interest rates. The operation's name was inspired by the dance created by Chubby Checker in 1960 (the Twist).
There are, however, some important differences between the institutional context of the early 1960s and today.
The quantitative easing measures undertaken by central banks in 2009 and 2010 were driven by the fact that key interest rates had already been reduced to their lower bound of essentially zero (Fed, BoE and even Japan in recent years), i.e. it was no longer possible to lower long-term rates by cutting short-term rates. In contrast, in February 1961 short-term rates were well above zero; for example the 3-month T-bill hovered around 2.26%.
In 1961, the United States intervened to lower long-term rates, as opposed to cutting them to about zero, like today, because the country was then operating under the Bretton Woods fixed exchange-rate system entailing gold parity (the gold standard) then in effect for the world's major currencies. Since European interest rates were higher than those of the United States, any unilateral move by Washington to cut short-term rates would have led cross-currency arbitrageurs to convert US dollars to physical gold, thus putting pressure on the Fed's debt reserves.
It is worth noting, however, that this maneuver did not stop America's trading partners from ordering huge conversions to gold in the 1960s, as exemplified by then French president De Gaulle's decision in 1969 to send a Destroyer to pick up $300 million in gold from the Fed. With that purchase, America's gold reserves contracted from 67% to 16% of the world's gold reserves in 1970!
The Fed's Recent Quantitative Easings
Today, with the dollar trading freely on forex markets, following Richard Nixon's decision of 15 August 1971 to end automatic gold conversion, the Fed has the latitude needed to set key rates at a level it deems appropriate. And it has made ample usage of this freedom, given the setting of the Fed Funds rate at 0.25% since December 2008. Moreover, it announced following its 9 August meeting that it will maintain this zero-interest-rate policy until at least mid-2013!
The only real "victims" of these zero bound rates are those intent on accumulating dollars, regardless of the compensation level. We are talking about countries who have arbitrarily pegged their currency exchange rate to the dollar to subsidize their export sectors.
Since it could not further lower interest rates, the Fed decided in 2009 and 2010 to launch quantitative easing operations, via the purchases on the secondary market of government bonds. It figured that, in view of the economic situation and especially the danger of deflation, negative short-term interest rates (Fed Funds) would have been justified. And any long-term debt purchases would enable it, everything else being equal, to push down long-term rates for the same reasons used for the launch of Operation Twist.
Due to the mounting fears of hyperinflation, which have effectively hindered any new QE and any new growth in the Fed's balance sheet, many observers have concluded that the Fed's next move will resemble that of a new Twist in which it sells short-term debt in its portfolio (under 2 years?) and replaces it with long-term securities. As such, the balance sheet's net size would not change, but the average maturity would increase significantly and have a significant impact on the yield curve.
Since these short-term securities have a very small yield (0.05% on 6 months and 0.20% on 2 years), their exchange for long-term debt would generate carry trade gains to the central bank, which would enable to help the government improve its budget situation. It paid the US Treasury $79.3 billion for gains generated in 2010 and $47.4 billion in 2009!
There is almost unlimited demand for these securities, given their expected yield path for the period and investor preference for the safety and liquidity of short-term US treasuries, regardless of what the sad saps at S&P think.
Last but not least, the purchase of these longer-term, less liquid and more volatile debt securities should, everything being equal, drive down long-term rates, thereby generating additional savings for the US Treasury, which would be able to borrow more cheaply. As I say, everything being equal, because we need to disassociate the impact of the operation itself, which will lower interest rates, from its psychological impact which, like the QE2 of 2010, was largely anticipated and which resulted in a hike in long-term rates following the improvement in the economic situation in Q4 2010.
As for the monetary impact, estimates vary, but the latest figures I have seen calculate that such a shift in the Fed's debt portfolio from below 2-year toward 10+ year debt would be equivalent to the gross strength of the QE2 ($600 billion).
This analysis, which may appear very positive, does not mean that I believe that this sort of operation, in the current circumstances, will be automatically good for the American economy. I can think of two problems right off the bat:
First, these carry-trade revenues, in reality, represent a net drain by the American government on private-sector revenue, in much the same way as a tax. It is thus a fairly contradictory way to prop up aggregate demand. As usual, it amounts to an eminently political act, albeit a less visible way to redistribute revenue from savers to the rest of the population.
Second, durable purchases of more targeted instruments, like mortgages in 2009 and (why not?) consumer debt and other packages, would probably have more impact on the interest rates that really count for the private sector, particularly on the mortgage market, which could use it.
Euro Twist?
In the course of its purchases of peripheral eurozone nation debt (Greece, followed by Ireland and Portugal, and now Spain and Italy) via its Securities Market Programme, the ECB always emphasized the sterilization of said purchases, unlike in the United States.
This enabled a beloved central bank to strike a virtuous posture (as per Austere Austrian Ostriches) by claiming that they were not really injecting money in the the system or printing money. However, like most of the ECB's posturing, there argument made no sense.
It changes nothing as to the reality of the operation, be it for those who sold their securities in SMP operations and who could end up in a pure liquidity position, like the banks in the United States (resulting in surplus reserves for banks). This liquidity would have been redeposited day after day at the ECB. Instead, this money is tied up for a week via the ECB's weekly tender calls. In each case, the two central banks are in reality practicing a yield curve operation, with the Fed borrowing short-term overnight with the Fed borrowing on a weekly basis) in order to buy longer-term maturities on the market.
The only notable difference is that the Fed is financing itself at its deposit facility rate of 0.25% whereas the ECB has already paid higher at the weekly rate (1.15% last week), even when its own depository rate was still at 0.25% (0.75% today).
Consequently, the ECB's SMP operations bear more resemblance to the 1961 Twist operation than the Fed's recent QEs. The ECB is not offering pure liquidity to the (aggregate) financial system, but weekly instruments closer to the T-Bills issued by the US Treasury in 1961 as part of its drive to shorten the average maturity of its debt portfolio.
And if we dig a little deeper, we see that the ECB's line that the SMP operations are "used to restore the transmission channel of monetary policy," we can only conclude that governments must no longer have recourse to these operations, which is precisely the opposite of what the ECB has been relentlessly insisting upon. It has done so via its demands for a qualitative and quantitative boost in the resources and responsibilities of the EFSF so that it picks up where the SMP leaves off.
To put it kindly, while this incongruity in the ECB's attitude comes as no surprise to those who have been following it closely, it only exacerbates its massive credibility deficit precisely when it needs it most to offset the lack of consistency/coherence of eurozone government leaders, as amply exemplified by the ridiculous demand by the Nordic bloc for a PSI and collateral.
The only point at which our analysis coincides with that of the ECB is on the quantitative level. In order to restore its monetary policy transmission channel, the ECB needs to influence sufficiently the long-term interest rates of eurozone countries to bring their yield curves in line with the present and future macroeconomic situation.
Given the current context, with austerity plans spreading like the plague over the entire eurozone (I have kept the Schaueble FT article for tomorrow; it's a a real gem!), who really believes that 10-year Spanish and Italian bonds should be trading above 4%, not to mention at 6.20% like today? On the other hand, aren't German rates of 1.90% a bit low, even for the most convinced proponents of a Japanese scenario?
This sort of thing is bearable as long as the effects of these aberrations are limited to countries already under life support via European financing programs (Greece, Portugal, Ireland) and whose financing costs are thus unaffected. Especially since the weight of their GDP within the eurozone is so low that it does not influence the European yield curve by weighting.
But when it involves two heavyweights in the zone, such as Spain and Italy, who also continue to raise debt on the market, the ECB's monetary policy objectives must lead it to intervene without size limits on these countries' secondary markets to bring their long-term rates down to levels consistent with the economic situation. By so doing, it can ensure their survival and that of the eurozone itself.
The ECB thus has the resources to confront this challenge; its leaders only lack the courage to recognize the inevitable of this measure and carry it out. Clearer communications with the market would enable it to both recover part of its lost credibility while limiting, via an announcement effect, the sums involved.
Some will object that the Germans (Bundesbank) will never agree to such a measure.
However, let's see what the Bundesbank said in its September 1990 report:
“A monetary union is an irrevocably sworn confraternity ‘all for one and one for all…”
As Trichet so coyly remarked in his last press conference, in response to a question from a journalist about the lack of unanimity on the ECB Governors Council on the question of extending the SMP to Italy and Spain, Council decisions are make on a majority basis, meaning that Europe still have the power to impose its will on the Bundesbank, whether it likes them or not.
The latter's only option would be to call for Germany to leave the eurozone, but such a demand must can only be formulated by the government, not the central bank. And even if certain newspapers playing on popular opinion or certain parties whose political and/or political credibility is in shatters, such as the FDP (how we miss the days of Hans-Dietrich Genscher), the forward-looking wings of the CDU, SPD and Greens remain fervent supporters of European integration, and even eurobonds.
But even if Germany's governmental leaders were to consider a unilateral exit from the eurozone (with its DM bloc neighbors), they would still have to explain to their citizens the short-term costs such a move would entail for them (all euro-denominated assets held by banks, insurance firms and pension funds depreciated immediately) as well as the longer term costs, given the return of sequential competitive devaluation resulting in the loss of a captive domestic (eurozone) market.
In short, the ECB Governors Council has the resources at its disposal to help the eurozone, and by ricochet other developed economies, overcome its worst economic crisis ever.
Being an incurable optimist, I can only hope that Trichet will have the elegance to establish such a plan before his departure, thus leaving his successor, Draghi, whose Italian nationality would make him suspect to initiate such a move, as ridiculous as any such notion may be.
Unfortunately, we have been disappointed so often, I am unwilling to predict any such scenario in the near term. So it looks like we have several more months of tension ahead of us.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am long 18 years OAT and 28 years BTP Zero Coupons, EDF Corp 3 Years 4.5%, Greece 1 Y and 8 Y bonds.
