Tuesday, September 20, 2011

C'mon Baby, Let's Do the Twist!

From the Desk of Joe Rollins

The Federal Open Market Committee (FOMC) began their 2-day meeting today on interest rate policy. At the meeting’s close tomorrow, investors are anticipating Fed Chairman Ben Bernanke’s announcement of ‘Operation Twist Light,’ a plan wherein already low long-term interest rates would be decreased to an even lower level.


At last month’s FOMC meeting, most members supported additional policy measures to help encourage a stronger economy, even though Bernanke didn’t talk about the possibility of the Fed taking further action in his Jackson Hole speech last month. The market’s performance over the past month, however, has made it clear that the market expects the Fed to take some modest action, although it’s not demanding another full-on round of quantitative easing.

How would ‘Twist Light’ work? By increasing the timespan (longer maturities for the bonds) – but not the amount – of the securities held by the Fed (approximately $2.6 trillion). And unlike the full-fledged Operation Twist program instituted in 1961 that it was named after, the Fed wouldn’t be selling short-term securities to buy long-term debt. Rather, the Fed would “begin passively increasing [its portfolio’s] average maturity” by investing its available cash and reinvesting its longer-term mortgage-backed security proceeds.


The hope is that the extension of the Fed’s portfolio holdings would cause long-term interest rates to reduce, making it more desirable for companies to invest their stockpiles of cash. Theoretically, it would also allow for better borrowing terms and an increase in household spending while boosting employment and keeping prices from falling.

And what about the potential benefits to the market? Optimistically, Twist Light would help nudge investors away from deposits and riskless assets, taking the market higher. Even so, if the FOMC passes Twist Light – and it probably will, even with Philadelphia Fed President Plosser and Dallas Fed President Fisher expected to dissent – analysts generally aren’t counting on a huge impact to the market. Rather, rallies on both the upside and downside will likely continue through the end of the year.

The most important facet to Twist Light is that there would be no monetization plans (i.e., printing of new money). Unlike QE1 and QE2 wherein the Fed printed new money to purchase securities, none of that will take place in Twist Light. Since there’s no expansion of the monetary system and only an extension of the terms, I can’t see how it would hurt – and it might just help. The Fed certainly has my blessings to proceed.

Of course, with long-term yields already at low levels and with low borrower demand, there is some debate as to whether this action would really provide any economic benefits. After all, even worthy borrowers have thus far been uninterested in taking loans from banks that are sitting on hoards of cash. However, with unemployment continuing to hover at approximately 9% and with stalling growth, Twist Light seems to be a reasonable effort for the Fed to undertake.

Stay tuned to see what happens next…

Best regards,
Joe Rollins

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