Gavin Graham writes:
In what was regarded as the most widely-leaked decision in recent Federal Reserve history, the U.S. central bank announced on Sept. 21 that it would be selling $400 billion (figures in U.S. dollars) in short-term government debt (less than three years to maturity) and buying the same amount in long-term debt (six to 30 years maturity).
This manoeuvre has been nicknamed Operation Twist after a similar move that the Fed employed 50 years ago in 1961, when The Twist was a popular dance. The theory is that the move will "twist" the yield curve by reducing long-term interest rates and raising shorter-term rates, leading to cheaper finance costs for businesses and homeowners while encouraging economic growth.
The Fed held $2.64 trillion worth of securities in mid-September, of which $1.65 trillion was in Treasuries and $995 million in mortgage-backed securities. So Operation Twist is equivalent to around 25% of its Treasury holdings. The average maturity of its debt is 6.1 years. The Fed also announced it would reinvest its maturing mortgage debt back into mortgages rather than Treasuries.
The reason the Fed decided to employ this rarely used strategy is its gloomy view of the U.S. economy. "There are significant downside risks to the economic outlook, including strains in global financial markets," a statement said. Operation Twist is "intended to put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative".
Previously, the Fed committed in August to leaving its short-term federal funds rate at the 0-0.25% level for two years to mid-2013, and indicated in its statement that inflation "appears to have moderated since earlier in the year" with its core inflation rate, excluding food and energy, rising 1.6% in 2011 to July.
So what can we expect from this move? In 1961, long bond yields fell 0.15%. However, as U.S. 10-year Treasury bond yields hit a 60-year low at 1.94% on the day that the Fed came out with its announcement, having fallen from as high as 3.74% in February, it is difficult to foresee Operation Twist having much of a further depressing effect on long-term bond yields. Even if there is some impact, U.S. companies have record amounts of cash on their balance sheet, and even with the present exceptionally low level of interest rates, are unwilling to invest in new capital equipment and hiring more workers.
Moreover, it is not the high level of mortgage rates that is depressing U.S. house prices, as 30-year rates are at 40-year lows at 4.07%. The problem is the fact that U.S. housing prices were down 5% over the last 12 months and that over half the home sales this year have been repossessions being put back on the market. This has left new home starts and new and existing home sales at 20-30 year lows.
Low interest rates, whether short or long term, have not been sufficient to get the U.S. economy moving again or to reduce unemployment below 9%. Until the overhang of unsold houses is cleared and companies have some visibility and confidence in the direction of U.S. fiscal and tax policy, the attempts by chairman Ben Bernanke and the Fed to stimulate the economy, whether through moves such as QE1 in 2008-09 and QE2 last year or market manoeuvres like Operation Twist and fixing short-term rates for prolonged periods, are doomed to failure.
With political opposition mounting to another QE operation, which opponents regard as simple money printing, Mr. Bernanke has other weapons in his armory, such as reducing or eliminating the 0.25% interest it pays on balances that the commercial banks keep with the Fed or buying more securities.
In his famous 2002 speech titled "Deflation - How to Ensure 'It' Doesn't Happen Here", which gained him the nickname of "Helicopter Ben", he listed Operation Twist as one of the tactics a central bank could use to defeat deflation if short-term interest rates had reached the zero level.
He also indicated that amongst the securities that a central bank could consider buying were not merely government bonds, or even mortgage-backed securities, but corporate debt and perhaps (by implication) equities. Mr. Bernanke has noted that he feels rising equity markets make consumers more confident and increase wealth, or at least people's perceptions of their wealth. Perhaps we may see the Fed's next effort involve the addition of equities to its balance sheet.
It is difficult to imagine U.S. government long bond yields falling much lower than the 1.9%-2% level that the 10-year Treasuries are trading at now but the continuing collapse of the eurozone may see "safe-haven" money flowing into the best performing asset class after gold over the last decade.
Whether rates even as low as 1.75% or 1.5% will reignite the U.S. economy remains to be seen. Certainly Japan's experience over the last two decades is not encouraging. As Mohamed El-Erian, CEO of influential bond house Pacific Investment Management Co. (PIMCO), told Bloomberg News: "While Fed purchases can influence Treasury and mortgage valuations, it is limited in its ability to deliver economic outcomes."
Canadian investors should be cautious about buying foreign government bonds at record low yields unless they believe that deflation will triumph in the next few years.