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10Y and 30Y yields (^TNX, ^TYX) have pierced the levels that they were at prior to the Fed’s announcement of Operation Twist.

As a consequence, the risk is increasing that that Operation Twist will be perceived to have been a failure.

It is a moment of great significance when it becomes widely perceived that a central bank is unable to stimulate economic growth without provoking significant inflation.

What Rising Long-Term Yields Mean

If the trend is sustained, rising long-term yields (IEF, TLT) are a telltale sign that the US Fed has essentially lost control of its ability to benignly control long-term interest rates. It is a signal that the Fed will not be able to stimulate the US economy without generating significant amounts of inflation.

To the extent that yields were rising because investors were anticipating higher levels of real GDP growth, the Fed’s credibility need not be damaged. This is precisely what occurred within days of the official announcement of QE2. Yields rose steadily for weeks. In this particular case, Fed credibility was not affected because the reason for the decline in Treasury Bond prices and the rise in yields was that financial market participants were anticipating a pick-up in growth. The stock market (^SPX, ^DJIA, ^IXIC, ^NDX, SPY, DIA, QQQ) rallied and economic growth ultimately did accelerate, thereby vindicating Fed policy.

But what happens if long-term Treasury yields actually start to rise, the stock market stagnates or falls, and real GDP stagnates or decelerates?

Game over. Fed credibility regarding its dual mandate is lost.

At this point, the Fed will be forced to confront a terrible predicament:

  • Option #1: Abandon program of monetary stimulus in order to bring inflationary expectations under control (the expectations that are causing long-term interest rates to rise). This policy would risk depression and high unemployment.
  • Option # 2: Accelerate monetary stimulus despite rising inflationary expectations. This would propitiate high inflation.

Can Interest Rates Rise In A Contracting Economy?

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.

If trust in the US dollar (NYSEARCA:UUP) becomes eroded, inflation can accelerate very quickly.

The notion that high inflation is primarily a function of the quantity of money is a myth. A related myth is that inflation cannot occur in the context of deleveraging (with its concomitant contraction of the money supply).

High inflation is triggered by a loss of confidence in the currency, and this can happen whether the money supply is expanding, stable or contracting.

Conclusion

I have said on numerous occasions that Operation Twist is a policy with very limited upside and enormous downside.

The recent rise of long-term Treasury yields in the face of evidence that the economy is decelerating is an early warning sign that the risks of this policy are already tilting to the downside.

Any loss of confidence in the US dollar could set off a chain of events that would lead to a spike in long-term interest rates (LQD, JNK, HYG).

Far from being able to prevent this outcome, Operation Twist could actually accelerate it. The rise of long-term interest rates in the face of Operation Twist erodes Fed credibility; it generates a feeling that the Fed has lost control over monetary variables.

In particular, the feeling that the Fed has lost control of inflationary expectations and interest rates is a key element in an inflationary dynamic.

Source: Operation Twist In Danger Of Failure: Fed Credibility At Stake

Additional disclosure: I am short TLT