THE markets were hoping for a helicopter drop from the US Federal Reserve this week, a reference to Ben Bernanke’s infamous 2002 speech on how to prevent deflation. What they got was more a paper plane, where the Fed will fly Treasury bonds from the short to the long end of the interest rate curve. The resultant sell-off in stocks and increase in the dollar reflects the disappointment with the lack of a third round of quantitative easing (QE3), or hints thereof. Beyond this though, Operation Twist is unlikely to deliver the required boost to the economy and here’s why.
First, there’s the starting point. By selling its holdings of short-dated securities (less than three years maturity) and buying long-dated securities (anything from six to 30 years left to maturity), the hope is to lower the yields – which move inversely to prices – on Treasuries, which feeds through to corporate and household borrowing costs. And during the first Operation Twist back in 1962, when The Twist was actually dance-floor fashion, the Fed succeeded in pushing down 10-year Treasury yields to the 1.85 per cent level. But this was the level that US yields were already at going into last night’s decision. In other words, the Fed is now starting from the previous end-point.
Second, by selling short and buying long on such a scale ($400bn), the Fed is clearly trying to flatten the yield curve, which will come via falling long-dated yields and possibly higher short-dated yields. But in doing so, banks will be further squeezed on their profitability, given that the margin on borrowing short-term funds and lending long (in the form of mortgages, for instance) will be further reduced. Interestingly, the spread between two and ten year yields is currently 155 basis points (bps), which equates exactly to the average of the past ten years and is some 80bps below the average since Lehman’s demise three years ago. Already we are seeing mortgage rates react to this, so even though the US 10-year yield may be at multi-decade lows, the difference between mortgage rates and Treasury rates has been widening dramatically in recent weeks. While 10-year Treasury yields fell 1 per cent to 1.85 per cent, equivalent mortgage rates have fallen only 0.2 per cent. In other words, Operation Twist could be more about prevention of higher borrowing rates rather than curing the economy by pulling them substantially lower.
Third, to be effective in pushing bond yields substantially lower, US yields would have to approach levels currently prevailing in Japan, where 10 year yields are near to 1 per cent. But Japan can finance government debt twice the size of its economy thanks to a captive pool of domestic savers. In stark contrast, the US is reliant on overseas investors, who hold nearly half of marketable Treasury securities. Will they be happy to finance the US deficit for a return of 1 per cent? It’s possible, but the road to equivalence on US and Japan yields is not going to be plain sailing by any means.
Finally, at this point in the cycle (flirtation with recession), the lack of any hint of QE3 goes against Bernanke’s 2002 speech where he stated “by moving decisively and early, the Fed may be able to prevent the economy from slipping into deflation”. The Fed managed this at the beginning of the crisis, but is erring away from it at the current inflexion point. This is not the time to be timid.
So how can the Fed be bold when rates are practically zero and two rounds of QE have already been undertaken? There remain numerous possibilities, not least another dose of QE. In terms of government bonds, the Fed still owns around 18 per cent of outstanding government bonds, versus over 20 per cent in the UK after just one round of QE. There remains scope for reducing or eliminating the interest rate on excess reserves held at the Fed, encouraging banks to lend funds out. There’s also the possibility for an explicit target for any of bond yields/nominal GDP/inflation/the unemployment rate (but certainly not all simultaneously). Alternatively, there is also the more radical suggestion that the Fed could lend indirectly to the private sector using the banks as the conduit. Utilising the discount window, the Fed could lend at virtually zero interest rates to the banks, in turn accepting collateral on quality private sector assets such as corporate bonds, commercial paper, bank loans and the like. This in turn would potentially significantly lower the cost of capital for both banks and the non-financial private sector.
It’s more likely than not that some of these options were discussed at this week’s meeting, but the Fed Chairman was unable to convince recent dissenters of the merits of these more radical approaches. Like it or not though, many debt-laden developed economies are suffering from piece-meal policy responses and Operation Twist will eventually be labeled as just another one of these.
Simon Smith is chief economist at FxPro.
The Fed acted decisively at the start of the crisis but is erring away from that now