Thanks to the poor economic situation plaguing America, a number of proposals have been released in order to try to end this malaise. Massive stimulus was thrown at the market by leaders in D.C. while the Fed sought to do its part by embarking on multiple rounds of quantitative easing. These purchases of government bonds helped to push down rates for many short-term debt securities but did little else when it came to jump-starting the economy. Yet, with political gridlock afflicting Washington, no relief seems to be on the horizon from the Federal government, leaving Bernanke and Co. as the only hope for those who are begging for more stimulative measures.
Thanks to this pressure, all eyes will likely be on the Federal Reserve and its highly-anticipated FOMC meeting this week. Many will look for the group to announce further plans for easing, or at least a shift in the policy tools currently being employed. While some are hoping for a reduction in interest paid on bank reserves held at the Fed, others are pegging their expectations on more easing with an increase in bond buying. While either of these situations is certainly possible, the latest talk has all been focused in on what is known as ‘Operation Twist.’
In this plan, the Fed would exchange its short duration securities for those further up on the maturity curve, in essence, increasing the duration of its Treasury security portfolio. This method would have the effect of bringing up rates slightly on the short-end of the curve while simultaneously lowering them on the mid or long end. ”The way we looked at it, it looks like they could sell something like $265 billion — everything they hold through June 30, 2013 — and that could be absorbed with very modest rate movement,” said Thomas Simons, money market economist at Jefferies & Co in New York. Hopefully, lower rates on longer term securities would help to drive down borrowing costs for everything from cars to houses, theoretically boosting demand for these products in the process and driving the economy higher.
Do The Twist
With that being said, investors should note that ‘Operation Twist’ has already been tried once before, and had limited impact on the markets to say the least. In the early 60s, the Kennedy administration got the Fed to work with the Treasury in order to sell short term bonds and use the proceeds to buy longer term ones. This move looked to shift the supply of short and long term debt available to investors and artificially drive up prices for long term bonds. Unfortunately, the policy didn’t have the desired effect in the 60s– lowering yields by about 15 basis points according to some sources– but it is important to realize that the tactics are a little different this time around. In the 21st century version, the Fed will be exchanging securities it already owns– instead of getting the Treasury to artificially print more of the short term variety– for longer term ones, so while it will be similar to the 60s policy, it will also have some key differences that could make the overall effect more (or less) this time around.
No matter what happens, investors should realize that there are a number of ways to play the possible move by the Fed later this week. Below, we have highlighted three of our favorite choices in order to benefit from a resurrection of ‘Operation Twist’:
Barclays 7-10 Year Treasury Bond Fund (IEF)
For investors expecting a modest increase in the Fed’s duration profile, IEF could be the way to go. The fund tracks the Barclays Capital U.S. 7-10 Year Treasury Bond Index, which measures the performance of American Treasury securities that have a remaining maturity of at least seven years and less than 10 years. This focus results in a portfolio that has an average maturity of about 8.6 years with a 30 Day SEC Yield of roughly 1.7%. If the Fed decides to cycle into these types of securities, it could further add to the stellar performance of this fund year-to-date. In fact, IEF has gained 6.7% over the past quarter and nearly 10.8% since the start of January, suggesting that a move to longer dated securities could help keep this fund above the double digit return level for the 2011 period.
Barclays 20 Year Treasury Bond Fund (TLT)
If you think that Bernanke is looking to vastly increase the duration of the Fed’s portfolio, this ultra-long focused fund from iShares could make for an interesting choice. The product tracks a similar index to IEF, the Barclays Capital U.S. 20+ Year Treasury Bond Index, but only focuses on bonds that mature in at least 20 years. The portfolio currently has a duration of about 28.1 years and pays out a pretty solid yield of 3.2%, when measured by the 30-Day SEC metric. In terms of performance, TLT has had a pretty solid run, gaining 15.8% in the past quarter and just over 20% in the past six months. However, with that being said, the fund has declined by about 1.3% in the past week so a move by the Fed to drastically increase the duration could help to get this popular Treasury fund out of its recent slump.
US Treasury Flattener ETN (FLAT)
For a more interesting, and potentially more lucrative, way to play a potential “Operation Twist”, investors should take a closer look at this unique ETN from iPath. The fund tracks the inverse of the Barclays Capital U.S. Treasury Two Year/10 Year Yield Curve Index which seeks to capture returns that are potentially available from a ‘flattening’ of the U.S. Treasury yield curve. The note does this by going long in two year Treasury bonds and simultaneously going short in the ten year variety, profiting when short term rates rise and longer term rates fall.
If the Fed goes through with Operation Twist as many think it will, this fund could stand out as a beneficiary, gaining from both a increase in yields in short term securities and a decrease in longer term yields. However, investors should note that the fund still isn’t the most popular product on the market, trading about 60,000 shares a day, suggesting it may not be appropriate for big active traders. Yet for those looking to make a bet on a flatter yield curve, this is really the only game in town and should be watched closely no matter what Bernanke decides.
Disclosure: No positions at time of writing.
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