Markets Betting On Operation Twist

Includes: IEF, TENZ
by: Zecco

By Paul Quintaro

On Monday morning CNBC reported that in a survey the network had conducted, 70% of respondents predicted that the Federal Reserve would undertake an 'Operation Twist' in the near future.

Further, almost 80% of respondents who predicted Operation Twist believed that the Fed would act this week.

The Federal Open Market Committee (FOMC) is set to meet on Tuesday for the start of a special two-day meeting. If the Fed decides to roll out Operation Twist this week, the FOMC meeting may be the most likely time.

In the 1960s, the Fed conducted the original Operation Twist, and many are assuming that the Fed would follow a similar strategy now as back then.

Under the original Operation Twist, the Fed purchased long-term bonds in an effort to drive down long-term interest rates, rather than drive down shorter-term interest rates.

To drive down longer-term interest rates, the Fed may target a specific security.

Which longer-dated security would the Fed target? One possibility may be the 10-year.

The interest rate on the 10-year is typically used to set rates on various consumer loans, including mortgage rates. A lower 10-year rate may support a recovery in the housing market and help to reduce unemployment in the broader American economy.

Still, interest rates are at a historic low, as the yield on the 10-year remains near 2%. Would lowering the interest rate more make a noticeable difference?

Further, are market participants able to accurately predict the moves of the Fed?

Back in June, Bloomberg conducted a survey of foreign exchange professionals that found that nearly 2/3 of them did not believe the Fed would engage in a third round of quantitative easing (QE3).

Thus far, that prediction has proved accurate, as the Fed has not engaged in a third round after the second round concluded back in June. Still, an Operation Twist would in a way be a modified version of a QE3, as it may amount to the Fed purchasing more treasurys.

Does the Fed even need to act?

Former Fed Chairman Paul Volcker is skeptical of further action.

On Sunday, Volcker published an op-ed in the New York Times entitled, “A Little Inflation Can Be a Dangerous Thing.”

In the piece, Volcker argued that raising inflation in the economy (through further Fed action), even in the current economic state, was a dangerous move.

Volcker—although liberal politically—is a noted inflation hawk who is famed for having orchestrated the successful reduction in the rate of inflation in the early 1980s.

Volcker did not take aim at any specific FOMC members in his piece, but did state that, “at least one member of the Fed’s policy making committee recently departed from the price-stability concept.”

He may have been speaking about Chicago’s Charles Evans, who recently made comments that explicitly called for further action.

Wednesday afternoon may then set the tone for the week. Will the Fed unveil Operation Twist? If so, will we see the inflation Volcker fears going forward?

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