By Anthony Harrington
On September 21 the Federal Reserve launched Operation Twist, Mark II in what some commentators are already dubbing a disguised QE3. The essence of Operation Twist is that the Fed is going to attempt to push down rates at the mid-to-longer end of the yield curve by swapping short term debt for long term debt, to the tune of $400 billion.
The instant effect of the announcement was to put markets into a tailspin. The FTSE lost 5% in a day, the Dax over 4%, the S&P over 3%. Amid the gathering panic it was impossible to tell whether markets simply took Operation Twist as evidence that the Fed was worried and had an over the top, “Oh my God!” gut reaction which will fade in days, or whether the Fed's move simply crystalised all the bad economic news that has been gathering for weeks - in which case markets are likely to stay depressed until something happens to lift the mood. Or we go in the other direction and slide into a post-Lehman brothers style slump.
Caught in the blast
A serious longer term consequence of Operation Twist is likely to be the impact on pensioners and charities who rely on the yield from longer-term bonds as part of their monthly income. Driving down rates hurts them and pushes them to move their investments from low-risk longer-dated Treasuries to higher-yielding but more risky asset classes – moreover it does this at the very time when downside risks to equities and higher-yield corporate debt are rising sharply. Is this what the Fed should be aiming to do? Absolutely not. Which makes the pensioner population and the charitable sector collateral damage …
Then there are the banks, most of which are seeking to rebuild their profit base in trickle charge fashion, by borrowing short at low rates and lending long at higher rates. With a depressed rate for longer-dated Treasuries, bank lending rates on longer term debt has to fall as well, choking down that trickle charge to a much thinner stream. This, of course, is the whole point of Operation Twist, which aims to stimulate the flagging U.S. economy by driving down interest rates on mortgages, corporate bonds and credit generally. Bank profits will nevertheless take something of a hit, unless lower rates stimulate demand to the point where increased borrowing takes up the slack.
Right now this does not look likely. Corporates are, generally speaking, not making full use of the credit that is available to them, largely because political ineptitude in Washington has created so much fog they can’t see the wood for the trees. The Fed’s ability to cut through the murk and show businesses the way is thin to non-existent, and it has put itself squarely in the political firing line with its latest actions, since senior Republicans have been going out of their way to warn the Fed not to go in for QE3. They can be expected to complain loud and long about the FOMC’s latest intervention.
According to Gavyn Davies’s blog on the FT site, the impact on longer-term yield rates is likely to be around 50 basis points (half a percent). The Fed is going to be dumping a largish chunk of short term debt into market hands as it swaps out its short term holdings for longer-dated Treasuries. This has a similar effect, Davies points out, to what would happen if the Fed increased the monetary base, hence we are in QE3 territory.
Interestingly, while markets tanked, the news that the Fed was going in for what looks a lot like another bout of money printing had exactly the opposite effect on the dollar to what might be expected. The fear the Fed’s move sent rippling through the markets, set off a flight to safety. When the world gets really spooked old habits kick in and everyone flees to the dollar as the deepest and “safest” liquidity pool on the planet. So you devalue your currency and, for a brief moment at least, everyone wants it, go figure …
Oh, one more thing. Not unexpectedly, gold tanked as the dollar rose, now that’s what I call a fine store of value …