In the 1960s, the Federal Reserve attempted to conduct an operation to lower longer-term yields and raise short-term yields. This maneuver was called “Operation Twist,” and the purpose was to stimulate private-sector borrowing and spending. It is generally agreed that the policy was modestly successful in temporarily pushing long-term rates lower.
There are rumblings of a similar operation being considered today by the Fed. The Fed has already indicated that it expects to keep short-term rates very low for an extended period, through mid-2013. One effect of this commitment is to flatten out the yield curve to two years. Supposedly, the Fed is considering taking the additional step of buying longer-term Treasury bonds and selling shorter-term securities in order to flatten the curve beyond two years, perhaps out to ten years. Lower long-term rates, it is believed, would generate mortgage refinance activity and other private sector borrowing.
Is this a good idea?
Is it likely to work?
Bill Gross, co-Chief Investment Officer of PIMCO, believes the answers are no and no. He suggests in a Financial Times editorial1 that the likely consequences of such a strategy, were it to be successful in flattening the curve, would actually be to destroy credit expansion. In a flat curve, his argument goes, there is little incentive for banks to lend or investment companies to lever. So further Fed easing would be contractionary.
PIMCO appears to be betting on this analysis. After dramatically reducing Treasury positions and portfolio duration last spring, based on a forecast of rising Treasury yields, Gross appears to have reversed this strategy in recent weeks. Treasury positions are sharply higher as of August 30, and portfolio duration has increased by two years. This suggests that PIMCO has been buying longer Treasuries in size. This position will look good if the Fed does deploy a twist strategy, and will look doubly good if the consequence of that strategy is to destroy credit creation and further weaken the economy.
Yield Curve Theory
Economists generally believe that long-term interest rates reflect the market’s expectation of future short term rates plus risk premiums that are higher the further out on the yield curve that you go. The existence of positive risk premiums is the reason the yield curve typically has a positive slope. This positive slope enables banks and investors to make profits by investing in longer term securities to enjoy higher yields and “roll-down” profits as the securities mature.
When overall interest rates are low, the slope of the yield curve tends to be steeper than normal, due to market expectations of rising rates. A steeper curve provides an incentive to go out farther on the curve and utilize greater leverage, if available. It also generates increased risks.
Typically, the part of the curve with the greatest slope is from zero to two years. But today, thanks to the Fed commitment to keep rates low for two years, the curve is flat out to two years and then steepens. If the Fed does conduct Operation Twist II (QE3), then the curve might be flat out to five years or more. Gross says that this would depress credit expansion by forcing banks and investors to hold cash. Of course, it would be possible to move aggressively into even longer-term maturities, but Gross suggests that is unlikely as “regulators generally frown on these maturity extensions.”
They sure do. Regulators still remember the thrift crisis which was launched by thrifts holding long-term fixed rate mortgages funded with short-term deposits during a period of rising interest rates. Thrift executives were excoriated at the time for their willingness to be exposed in this way. Of course, they had little choice in that most loan customers wanted fixed loans, most deposit customers wanted short-term deposits, and hedge vehicles were not available back then.
Today there is greater flexibility. If you want, you can emulate the PIMCO strategy of reaching out along the yield curve. Should you do so? After rising from the 1950s through the early 1980s, interest rates have been generally falling for the past thirty years. Rates today are at 60-year lows.
The “ride the yield curve” strategy works when rates are flat or falling, but does not work well when interest rates are rising, even if the slope of the curve remains positive. There are bond portfolio managers who entered the business in the early 1950s, retired by the early 1980s, and spent an entire career watching every bond they bought decline in value. But at least they were able to reinvest coupon payments at higher yields.
Conversely, people entering the business in the early 1980s have enjoyed a long-term bond rally. Every Treasury bond they ever bought has risen in value (at times you may have had to wait a year or so). I think many people have learned to ignore the risk of rising interest rates.
In all likelihood, PIMCO will be sufficiently nimble to reverse the maturity extension strategy once the next rising rate cycle begins. But will you?
1 "'Helicopter Ben' risks destroying credit creation." Financial Times. September 6, 2011.