MacroScope

The Fed goes long

September 16, 2011

As the U.S. economic recovery stumbles, most observers Federal Reserve policy expect the central bank next week to announce an initiative to replace shorter-term securities on its balance sheet with longer-term ones in a bid to drive longer-term interest rates lower.

Fed watchers call the maneuver Operation Twist after a like-named Cold War-era initiative in which the Fed bought longer term securities with a similar objective.

A twist action could stimulate mortgage refinancing and push investors to invest in corporate bonds, which could spur business borrowing, or in equities, which might help stocks recover, the Fed believes. By adjusting the composition of its portfolio rather than launching an aggressive new round of bond buying, also known as quantitative easing, the Fed would be taking a relatively modest easing step, but be acting all the same.

Ethan Harris, North American economist for Bank of America-Merrill Lynch, says policymakers have good reason to be gradual:

Right now they have decided to adopt a slow but steady easing policy. The big dramatic moves have been garnering so much negative attention that the normal confidence-building effect you get from monetary easing was cancelled out. And that’s very important at this stage.

But how exactly would the Fed, which has bought $2.3 trillion in longer-term securities in the last two and a half years, rebalance its massive portfolio?

The Fed in 2010 bought longer-term assets in 56 separate operations. Purchases were concentrated in the 2 to 10 year maturity range, although purchases included other securities. In 2009, 80 percent of the Fed’s purchases were of securities in the 2 to 10 year range. It also bought securities in the 10 to 30 year range, in the one to two year range, and inflation-indexed securities.

So a safe assumption is that in any Operation Twist remake, the Fed would shift the maturities of its purchases out a few years. But certain durations are unlikely candidates: since there is little private-sector borrowing at around 30-years, there would be little point to the Fed buying at or near that duration.

Most corporate borrowing in the bond market is at 10 years or less, and residential mortgage rates are tied to Treasury rates at 7 or 10 years. So, look for purchases of securities in the 5 to 15 year range, and for the Fed to let securities of less than two years, which account for a sizeable portion of the Fed portfolio, roll off, if not actively sell them.

What do the mavens expect?

If the Fed were to liquidate three-quarters of its holdings with maturities between 6 months and 2 years, it could invest $205 billion over the next six months in 7 to 10 year Treasuries, Eric Green of TD Securities writes. Add to that mortgage-backed securities running off and maturing Treasuries, and the Fed would have about $380 billion for Twist II, Green estimates.

JPMorgan’s Michael Feroli expects the Fed to sell $300 billion to $400 billion in Treasuries with one to three years remaining to maturity and concentrate 70 percent of its purchases on 7 to 12 year securities, similarly over a six-month time frame.  The remainder of purchases would be in longer maturities.

The benefit from Operation Twist is the same as from QE (quantitative easing) — removing duration from the market should exert downward pressure on longer-term interest rates. Operation Twist has the added benefit of doing so without increasing reserves in the banking system, thereby avoiding the monetization and hyperinflation blather that accompanied quantitative easing.

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