The global market for fixed income is over $90 trillion USD. By my reckoning, yearly traded volume is well in excess of $300 quadrillion USD.
An Operation Twist program that buys up $40 billion or so of long-term US Treasury bonds (TLT, IEF) every month isn't that big a deal in market of this size. If the Fed does this for ten months as announced, this would represent about 0.4% of the total global bond market. And it would represent 0.00002% of global bond trading volume during that period.
You might be wondering: Why do I use the global bond market size as the benchmark as opposed to the US Treasury market size? Simple: Global arbitrage.
One cannot assume that when the Fed buys Treasury bonds in market this liquid that prices will rise, or that yields will fall at all. Why? Because there is a global marketplace where investors calibrate relative yields amongst fixed income instruments. As soon as the Fed purchases Treasuries and long-term yields (TNX, TYX) fall a few basis points, on the margin, current holders of Treasuries will be prompted to take profits and invest those funds on securities whose spreads to Treasuries has increased. Furthermore, it is hardly safe to assume that these securities will be US securities. They could just as easily be Brazilian sovereign bonds, or Russian corporate debt.
There is another key issue to consider here. When the Fed purchases long-term Treasury bonds at negative interest rates (T-Bonds at 2.0% and inflation currently at 3.8%) it is clearly “debasing” the currency for reasons spelled out in detail here. In this case, the debasement – the difference between the real (inflation-adjusted) NPV of the bond and the face value of the currency issued-- is of a magnitude of about 17%. This sort of operation has consistently served as an inflection point in the evolution of inflationary expectations in the history of inflation crises in various nations.
If investors begin to lose confidence in the Fed and the currency it has been entrusted to manage, they will begin to “put back” long-term Treasuries to the Fed en masse. There are currently over $15 trillion in US Treasuries with remaining maturities of over six years. Even if a small percentage of holders sell their bonds on the secondary market due to a loss of confidence, the Fed’s $40 billion per month program could become overwhelmed very quickly.
If sellers emerge due to a loss of confidence in the USD, in order to hold the line on long-term rates, the Fed would be obligated to modify the program, create more money and expand its balance sheet. This in turn would tend to fuel further skepticism towards the USD (UUP). History suggests that the situation could very quickly spiral out of control.
How much of a loss of Fed credibility will be entailed if after the Fed starts purchasing Treasuries, bond yields actually start to rise? The loss of face could have lasting impacts.
The notion that yields could rise despite Fed purchases is hardly unlikely. This is exactly what happened within days of the official announcement of QE2. Yields rose steadily for weeks; the market ran right over the Fed. Ultimately, in this particular case, it did not matter because the reason for the decline in Treasury Bond prices and the rise in yields was that the market was anticipating a pick-up in growth. The stock market (^SPX, ^DJIA, ^IXIC, ^NDX, SPY, DIA, QQQ) rallied.
But what happens if in the context of economic deceleration, LT Treasury yields actually start to rise?
Those that think that rising rates cannot happen in the context of economic contraction are not familiar with history. Look at Greece today. Look at Argentina or Brazil in the 1970s. All that is required for long-term yields to rise is for default expectations or inflationary expectations to become accentuated. This is a psychological phenomenon that hinges on trust. Trust is fragile.
Operation Twist is a policy with very limited upside and enormous downside. In the fullness of time, the Fed’s decision that was announced on September 21st may be seen as a major blunder. If so, it will be in part because Fed Committee members did not realize that nobody is bigger than the global bond market. Not even the Fed.
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 short TLT and long TBT and SBND