What Is Operation Twist Designed To Accomplish?

by: Tom Cullis

I liken the Federal Reserve's approach to monetary policy to the way a hydroelectric dam functions. The reservoir behind the dam controls the maximum potential of how much and how fast electricity can be produced, while the inlet valves to the dam and the outlet valves on the other side control how much water is actually allowed through the dam at any point in time.
In my analogy the reservoir is filled with bank reserves, the inlet valves are controlled by the banks and the outlet valves by the consumers of loans, ie the general public. Since the financial crisis began the Fed has dramatically raised the levels in the reservoir through QE and has tried to coax lending out of the banking sector by keeping short term rates near zero and promising to keep them there for the foreseeable future.
These efforts so far have failed to restore credit growth to the economy and the Fed has been forced to consider the option that the constriction point is not reserves or the banking system's willingness to lend but a shortage in the willingness to borrow.
Enter Operation Twist. Twist is simply the selling of short term bonds, which should lead to short term interest rates rising, and buying long term bonds, which should result in long term rates falling. The long term rate is what most consumers use to finance large purchases. If you buy a house you have the option of a 15 or 30 year mortgage and it is long term Treasury rates that influence the interest rate you will pay.
So far this is nothing new. What is different is the interpretation of how the Fed is going about doing the Twist. In my view there are several things that indicated this is simply a wild experiment and even the Fed is unsure of the potential results.
First was the August promise to keep the Federal Funds rate at zero for the foreseeable future. The markets treated this as a big fat nothing since it is expected that the Fed will continue to keep rates low until a recovery is well underway. The real purpose of that announcement wasn't to stimulate lending but to get the message out that no matter what other actions come they are committed to keeping short term rates low.
Second is the timing of the Twist in relation to the above announcement. The Twist raises short term rates and lowers long term rates but the Fed just recently promised to keep the shortest term rate of all, the overnight funds rate, at zero for at least another year. This leads me to believe that they are trying to establish a baseline to figure out how much of an impact the operation has. By promising low rates ahead of time they are trying to fix a major variable that could make the data coming out of this action difficult to interpret.
Third is the relatively small size of the Twist. While $400 billion sounds like a lot of money, it is actually very small because the main effect is from a shift in assets and not the addition to assets. Consider adding $10,000 to your retirement portfolio. You now have $10,000 more in assets in your account. Now consider selling $10,000 worth of shares in one company and purchasing another. The first situation has a much larger effect on your portfolio than the second does. In terms of the Fed, measures like QE are similar to simply putting more money into your account while the twist is more like selling one type of stock and buying another. The small size of the action strongly implies that there isn't a lot of knowledge about the outcome as if they were sure it would be positive. A much larger dose would be needed for it to have major ramifications in the broader economy and if they were sure it would be negative they wouldn't do it at all. A small size means caution is being exercised.
What does this mean as an investor? If the Fed is truly interested in the results of Operation Twist then they will abstain from any other major actions so that they can have clean information to base future actions off. This interpretation is bolstered by the fact that Bernanke is an academic and has built his reputation in a world where finding clean information is highly prized. Barring a major threat such as another Lehman Brothers, do not expect major news in the near future out of the Federal Reserve. Any releases from meetings in the near future will probably disappoint to the downside while they wait to gather data.

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

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