Tuesday, September 6, 2011

Super-Twist: Ben's secret weapon?

At the Jackson Hole meeting, Fed Chairman Ben Bernanke said, in effect, that he has some secret weapon(s) that they FOMC would discuss at its September meeting [emphasis added]:
In addition to refining our forward guidance, the Federal Reserve has a range of tools that could be used to provide additional monetary stimulus. We discussed the relative merits and costs of such tools at our August meeting. We will continue to consider those and other pertinent issues, including of course economic and financial developments, at our meeting in September, which has been scheduled for two days (the 20th and the 21st) instead of one to allow a fuller discussion. The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools as appropriate to promote a stronger economic recovery in a context of price stability.
Since he didn't specify what the "range of tools" were, they might be "secret weapons" of monetary stimulus. What could they be?

One of the much anticipated tools is a repeat of "Operation Twist", a Kennedy Administration plan to flatten the yield curve by buying longer maturity bonds in order to push down long term yields. The San Franciso Fed explains:
The Kennedy Administration’s proposed solution to this dilemma was to try to lower longer-term interest rates while keeping short-term interest rates unchanged—an initiative now known as “Operation Twist” in homage to the dance craze then sweeping the nation. The idea was that business investment and housing demand were primarily determined by longer-term interest rates, while cross-currency arbitrage was primarily determined by short-term interest rate differentials across countries. Policymakers reasoned that, if longer-term interest rates could be lowered without affecting short-term yields, the weak U.S. economy could be stimulated without worsening the outflow of gold.
This move has been so well telegraphed that Bill Gross announced that Pimco was extending the maturity of its portfolio.

What if there's more? Bruce Krasting provided a clue in this recent post. He speculated that Obama Administration is going to propose a gigantic refi program. If homeowners pay off their mortgages and refinance, that will create tremendous cash flows to MBS holders. The Fed happens to hold about $1T in MBS and all these pre-payments will give the Fed money to do an Operation Twist and buy in the long end of the curve without expanding their balance sheet. If they hold $1T in MBS and pre-pays are sufficiently high, then the program will be QE2 sized.

My first reaction was, "Wow! This is a form of Operation Twist on steroids - a sort of Super-Twist. Another QE2 sized purchase of Treasury bonds in the long end of the curve!" This would spark a QE2-style rally in risky assets.
Upon some more sober reflection, I realized that there are major drawbacks to this scheme inasmuch it is unlikely to have a significant effect on asset prices. First of all, major MBS holders are Fannie, Freddie and the Fed (3F). Most mortgage backed securities are priced at a premium and this re-fi program will pay investors off at par. Thus, 3F will be taking a substantial loss on their holdings.
There is another problem. Suppose that this re-fi program generates $X billion in pre-payments which get re-financed. Then $X billion of MBS supply will come back into the market. One of the ways that QE2 pushed up asset prices was because it ballooned the Fed balance sheet by pushing a wall of liquidity out into the market. This program is more of a variation of Operation Twist, which extends the Fed balance sheet out to the longer end of the yield curve, but at a cost. Depending on how it's implemented, I could see substantial movement in credit spreads but don't expect QE2-like effects.

Moreover, it isn't clear to me what the sustainable benefits there to flattening the yield curve. The last FOMC meeting statement indicating that rates would stay low for another two years encouraged financial institutions to get long the carry trade of borrowing short and lending long. An Operation Twist, or Super-Twist, that flattens the yield curve undoes some of those benefits - though it does provide an immediate boost to investors who are already positioned in the longer end of the Treasury curve.
I suppose that the market could focus on the fact that $X billion is available to the Fed to re-deploy on its balance sheet, which would be bullish. On the other hand, it could also decide that this program is net neutral to negative because of the costs involved.
If Super-Twist is indeed the major weapons in Bernanke's stash of "secret weapons", I am unimpressed and I bet that the bulls will be unimpressed as well.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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