The Real Reason Behind The Twist

Includes: BAC, IWC, IWD, IWM, QQQ, SPY
by: Turtle Management

There are a lot of articles out there recently that talk about the recent Operation Twist enacted by the Fed. I am adding to the surplus because most of them seem to miss the point of Operation Twist and the big picture. From what I have read, Operation Twist is going to everything from hurt the economy to prevent housing from falling another 20% from here. Some say it will boost the economy by flattening the yield curve which is what the Fed wants you to believe its purpose is.

The real reason the Fed is dumping their short term debt for debt with maturities of 6 to 30 years is (I’ll save you the suspense and tell you now explaining later) is the set up the country for inflation. We have approximately $14 trillion in debt that is on the books and tens of trillions more in liabilities that we irresponsibly ignore such as government pensions, unfunded medical and social security, etc that are off the books. There are only two ways in which we can make our debt more manageable (make it go away since we can't possibly pay it back in full). We can default on it or we can inflate out of it making our debt a smaller percent of our revenue (i.e. tax revenue). If we have a bunch of short term debt that constantly comes due and we have to roll it (go into the market and issue more debt to fund expenses) we cannot inflate out of it. The reason we cannot is that people will see inflation ticking up. Specifically, the bond market will see inflation rising and it will demand a high yield (cost of borrowing for the government) on the bonds that the government issues to pay for our spending.

The idea is to get rid of our deficit so that we do not have to keep borrowing $1.2T per year and shift the Treasuries on our balance sheet from short term to long term. This allows the government to inflate as the longer term bonds have a fixed rate. If inflation is higher than the rate that the government has to pay lenders, the lenders (in this case fixed income funds, pensions, grandma’s savings, etc) will lose and the government will win. A bank, like Bank of America (NYSE:BAC) before it tried to meddle in 1,000 different types of business, traditionally makes money off of the spread between what it pays depositors and what it receives from borrowers. This is no different in that the government will pay borrowers say 3% on average while it “receives” 6% from inflation.

Operation Twist will not save the economy from a recession by flattening the yield curve. The yield curve is already pretty flat as the 10 year was below 2% before Twist was even announced. This is a sneaky albeit brilliant long term set up for inflating out of our debt. As I have wrote many times before; short term the risk is deflation, long term it is inflation. Inflation is painful, just as much so as deflation, but in different ways. Inflation is the easier choice for politicians due to its stealth and public ignorance in failing to recognize that inflation is the same thing as a default.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.