A Twist On How To Play The Fed's Newest Gambit

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By Jason Jenkins

On Wednesday, the Federal Reserve announced it would proceed with a new $400-billion program that will tilt its $2.85-trillion balance sheet more to longer-term securities by selling shorter-term notes and using those funds to purchase longer-dated Treasuries.

It’s rationale?

The Fed is attempting to bolster a weak U.S. economy by launching a campaign to put more downward pressure on long-term interest rates over time and help the beleaguered housing market.

This same idea was launched by the Kennedy Administration more than 40 years ago and was duly named “Operation Twist.” The Fed will reinvest those proceeds from maturing mortgage and agency bonds back into the mortgage market – which demonstrates the general feeling of sustained weakness in the sector. Officials believe that by shifting their bond holdings they could stimulate mortgage refinancing and encourage the overall market into riskier assets – such as corporate bonds and stocks – without causing inflation.

The Market’s Down Today… But What’s the Long-Term Impact?

The Fed aims to flatten the yield curve in order to ease financial conditions and credit creation, and shift capital from investors and lenders to consumers. The premise is that in a consumer economy, the shifting of money into risky assets and from lenders to consumers will create a catalyst for consumption. The rebalancing creates wealth, by which investment in productive, but riskier, assets leads to job creation, rising wages and aggregate consumer demand.

But not everyone agrees it will work. Several economists argue that the approach is fundamentally flawed. If you flatten the yield curve, you reduce the incentive of those with funds to provide dollars for production and real growth. The new incentive is to go short and not long. Operation Twist’s flatter yield curve would take away the availability of long-term capital and present a landscape where funds would be reallocated to short-term investments in order to get the biggest bang for the buck.

And Now… How to Play It

What you have is a Fed Reserve Chairman who is a disciple of monetary policy and is under fire from Republicans on Capitol Hill and internally from some of his own Commissioners.

Operation Twist was already a known quantity for the markets. There was an initial sell-off in the stock market once word hit that there would be no announcement of further quantitative easing, and then markets kind of adjusted accordingly.

Furthermore, it seems like Ben Bernanke’s Operation Twist, while slightly larger than expected by about $100 million, won’t have much effect on the downward slide of the economy. The Fed Chair has done all that he can think of. He’s out of bullets and he knows it…

He has, in the last two months, stated several times that it’s Washington’s turn to do its part.

Late Wednesday the dollar soared against the euro, yen and U.K. pound. The rise came after a global equities sell-off as investors piled into safe-haven assets like… the dollar.

The euro was at $1.357, down about one percent from $1.370 the following day. As I wrote earlier this week, Alexander Green, our Chief Investment Strategist, wrote an article Monday recommending how to take advantage of what he believes is an oversold dollar: PowerShares DB US Dollar Index Bullish (NYSE: UUP). There’s plenty of upside.