Fed Opts To Extend Operation Twist, Which Will Likely Accomplish Nothing

Includes: EDV, IEF, TLH
by: Josh Cohen

Despite the predictions of two major investment banks about which I wrote yesterday, the FED opted not to launch QE3 today. While the FED did not announce QE3, it did elect the extend Operation Twist through the end of this year. I believe, however, that the extension of Twist will not be of much help to the real economy.

The idea behind Twist is that the FED sells some of its shorter-term assets while it simultaneously buys longer-term assets. The FED made the following statement today after the FOMC meetings closed:

The Committee also decided to continue through the end of the year its program to extend the average maturity of its holdings of securities. Specifically, the Committee intends to purchase Treasury securities with remaining maturities of 6 years to 30 years at the current pace and to sell or redeem an equal amount of Treasury securities with remaining maturities of approximately 3 years or less. This continuation of the maturity extension program should put downward pressure on longer-term interest rates and help to make broader financial conditions more accommodative.

The issue with the FED's Twist strategy is that long-term interest rates are already at record lows. Consider the following graphs from the St. Louis FED, starting with 10-Year Treasury yields:

Here is the 30-Year Treasury:

Finally, here is a graph of the 30-Year Mortgage rate:

The FED's hope for Operation Twist is that the extremely low long-term interest rates will encourage more borrowing and spending in the economy. The FED is also hoping to push investors into stocks by making the miniscule bond yields they are currently receiving even lower.

The question we have to ask ourselves, however, is that with interest rates already at record lows, why hasn't economic activity picked up? In my opinion, the answer is twofold. First, after a brief uptick, the economy has slowed considerably, and the number of jobs created on a monthly basis has slumped sharply. This has certainly made consumers more reluctant to borrow and consequently businesses less likely to invest:

Second, investors are extremely worried about global macro events, particularly the crisis in the euro. Hence, the trend toward holding more cash rather then less.

While it is possible there may be a brief rally in stocks this summer as anticipation for QE3 continues, I still believe that it is worth holding at least some portion of your portfolio in medium- to longer-term Treasuries simply as a hedge against your equity portfolio.

For medium-term Treasuries consider the iShares Barclays 7-10 Year Treasury Bond ETF (NYSEARCA:IEF) or the iShares Barclays 10-20 Year Treasury Bond ETF (NYSEARCA:TLH).

For longer-term Treasuries the Vanguard Extended Duration Treasury ETF (NYSEARCA:EDV) is a fine choice.

I certainly realize that if the economy improves and/or stocks rally, these Treasury ETFs will lose money. However, f you think of Treasuries strictly as a hedge against further economic weakness and/or a blow-up in the eurozone, then holding some portion of Treasuries in your portfolio makes sense.

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

Additional disclosure: I hold some Treasury bonds in my 401(NYSE:K)