A Dual View Of 'Operation Twist'

Includes: AGG
by: Russ Koesterich, CFA

On Wednesday, the Federal Reserve outlined its new “Operation Twist” program. The central bank will buy $400 billion of long-term Treasuries in an effort to lower long-term interest rates and spur lending and economic growth.

The announcement came as no surprise: It had been clearly telegraphed by the Fed. Nonetheless, stock markets fell after the announcement and 10-year Treasury yields dropped to levels not seen since the 1940s.

Below, two of our iShares blog contributors weigh in to explain the market’s reaction and the plan’s implications for equity and fixed income investors:

Russ Koesterich discusses stock market implications: The announcement brought home the cold reality that the Fed has run out of tools it can effectively use to promote economic growth. After all, short-term rates are already effectively at zero; long-term rates are low as well. The Fed simply does not have any arrows left in its quiver, or at least ones that will have a big impact. Investors, it seems, are feeling like they have been left, well, twisting in the wind.

That said, I still believe that growth over the next one or two quarters in the United States will be anemic, but the most recent data still suggests that a double-dip can be avoided. I believe the chances of a new significant contraction are about 40%, and the European banking crisis represents the biggest risk. But if you believe Europe can muddle through its crisis, and US growth will continue, albeit slowly, then today’s stock market sell-off looks extreme.

Matt Tucker discusses fixed income implications: We expect to see some yield curve flattening as the Fed buys longer maturity securities, but overall rates should remain in a narrow range. Remember that the Federal Open Market Committee has pledged to keep its benchmark interest rate between zero and 0.25% until 2013, which should keep short-term rates in a tight range.

With signals that economic growth may be anemic, we may see credit spreads widen and more volatility in risky sectors like high yield and emerging market debt. Investors should consider their tolerance for risk before adding to these sectors. In terms of flows, we are seeing strong interest this month in investment grade intermediate credit funds (potential iShares solution: CIU) and broad fixed income (potential iShares solution: AGG).

Disclaimer: Bonds and bond funds will decrease in value as interest rates rise.

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