The combination of higher unemployment, higher inflation and a close to zero fed funds rate has forced the Fed to look at alternative ways of implementing monetary policy in the short-term. The weakness of the incoming dataprompted the Fed to commit to keep the fed funds rate at close to zero level through at least mid-2013 in August. This is now widely seen as inadequate and the market uniformly expects the Fed to announce further stimulus at the end of the two-day FOMC meeting starting today.
Among the policy tools left in the Fed’s toolbox, including cutting the interest rate payable on bank reserves and strengthening its forward-looking guidance on short-term rates, the idea of the so-called Operation Twist has become the front-runner. The purpose of this operation, first used in 1961 and named after the popular dance at the time, is to lengthen the average maturity of the Fed’s holdings of Treasury assets. This can be achieved by purchasing assets at the long end of the yield curve which could be financed by refinancing maturing MBSs from the Fed’s holdings from QE1 and by selling an offsetting amount of the Fed's current holdings of shorter term bonds. The intended effect will be to lower long-term borrowing costs while leaving the size of the Fed’s $1.65trn portfolio unchanged. The policy rationale now, as was the case in the 1960’s, is that this can stimulate the weaker US economy without stoking inflation and currency debasement fears in the markets (or as the argument went in the 1960s, without weakening the link between the US dollar and gold).
There are several significant similarities between Operation Twist and the Fed’s QE programs and one key distinction. Operation Twist, like the Fed’s QE, would aim to go beyond short-term rates to lower yields at the longer end of the maturity profile. In other words, the Fed will commit to keeping forward overnight rates at record low levels by changing the composition of its balance sheet, which would in effect strengthen the Fed’s forward-looking guidance on short-term rates. This would also weaken the dollar’s forward yield differential against the rest of the world. Currently US 2yr forward 3-month rates stand at 0.46%, against a spot rate close to zero, which suggests that term premia are too high relative to the Fed’s policy stance. Furthermore both Operation Twist and QE involve Fed purchases of Treasury securities in open markets. This effectively reduces the need for the markets to finance the budget deficit (for comparison the Fed’s QE2 program amounted to 4.1% of GDP and 7% of the Treasury’s outstanding debt stock) and frees up some duration demand in private investor portfolios.
This brings us to the key distinction between the two operations. Both Operation Twist and QE replace the market’s Treasury holdings with a new form of public liability. In the case of the former it is short term Treasury debt and in the case of the latter it is bank reserves, or the Fed’s liability. The difference is that Operation Twist will not impact the amount of money supply, ore dollar liquidity, in the markets and hence the direct effects on the US dollar are limited. However, by increasing liquidity at the long end of the curve while also pushing up the supply of low-yielding short-term securities in market portfolios, policy officials will be hoping create incentives for investors to channel cash into the real economy, e.g. by buying private sector assets. This could impact the dollar though the risk sentiment channel – or via investor expectations of improved asset performance and capital market liquidity.
Fed Impact and the US Dollar
The effects of the Fed’s Operation Twist on the US dollar would ultimately depend on the quantity and the speed of the Fed’s purchases of long-term securities. This in turn will determine the effects of the Fed’s actions on the Treasury yield curve and potentially on other assets which will be the key transmission of the Fed’s actions onto the economy and investor incentives (or market sentiment). Based on the Fed’s current holdings of about $500bn of sub-3yr debt ($150bn expiring within 12 months) and an estimated $200-300bn of MBS maturing at the year-end, market expectations start at the mark of Fed purchases running at $50bn per month over 6 months.
In terms of the direct impact, the historic analysis implies that Operation Twist in the 1960s, which also amounted to about 2% of GDP on the current market baseline scenario, lowered long-term yields by about 15bps. This is significant as Fed research shows that a 15bps reduction is equivalent to the typical response of the 10yr Treasury yields to an unexpected fed funds rate cut of 100bps. This probably provides a reasonable benchmark for the Fed’s expected impact this time around. That said, the impact of the 1960s’ Operation Twist on private sector assets proved limited. For example only 2-4bps of the 15bps was passed onto corporate bonds, compared to the more significant impact of about 13bps for agencies.
The Fed could try and modify the effects of asset purchases, e.g. by dropping the IOER rate, which could release more liquidity into the market without expanding the Fed's balance sheet. To the extent that Operation Twist will push the time line of any eventual policy normalisation further out into the medium term the Fed can afford to do this as a way of dissuading cash hoarding. The Fed could also establish a new link between policy actions and a nominal real economy target based on unemployment and inflation, although the calibration of this will prove difficult in the short term and could pose problems in terms of managing policy communication and inflation expectations.
All in all, lower US long-term yields would offset some of the impact of the financial crisis on borrowing costs in the real economy, which will make private sector balance sheets look healthier and indirectly provide a boost for banks’ profitability by improving the quality of banks’ loans. To the extent that lower mortgage costs also make household mortgage debt look more sustainable, the Fed’s actions would also help reduce the risk of recessionary deleveraging and cash-hoarding by consumers given the recent historic collapse of consumer confidence and a slowing labor market.
The main risk, however, is that the Fed’s actions will have relatively little impact on the real economy. US borrowing costs are already at record lows and yet households have struggled to take advantage of refinancing opportunity due to negative housing equity. At the same time businesses have tended to lack the confidence rather than the capacity to invest. Furthermore, the risk is that the liquidity created by the Fed’s siphoning of short-end liquidity into real money accounts will be channelled back into Treasuries, by way of preserving capital and lowering volatility, or into emerging market assets as a way of picking up yield, rather than into loans to the real economy. Hence, the main risk into the year-end is that the Fed’s actions would destroy yield but not have a material impact on the growth outlook, resulting in a form of a liquidity trap.
In the short term, the dollar is trading heavily into the FOMC announcement as investors await the likely impact on forward US yield spread differentials although I suspect that much of this effect is already priced in and the risk is that the statement proves underwhelming. Fed’s actions would do little to remove uncertainty about the US economy, or market fears about a recession in the euro area and concerns about the spillover from the euro banking crisis onto global capital markets. Strong cross-asset correlations during periods when investors liquidate risk and raise cash will benefit the dollar as a liquidity haven. Over time, a flatter yield curve through lack of any cyclical uplift for long-term US real interest rates (the 10yr stands at just 0.05% at present) would be negative for the US dollar through increased dollar asset diversification flows.
Lena Komileva| Senior Vice President | Global Head of G10 Strategy
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