At the Fed’s policy meeting yesterday, Mr. Bernanke announced that what America desperately needs is a rearranging of the deck chairs. Facing opposition from, well, just about everybody who isn’t a trained Keynesian economist (read: those with common sense), the Fed decided to lengthen the maturity of its Treasury portfolio. Bernanke & Co. will sell $400 billion in short-maturity Treasury securities and purchase Treasuries with maturities of 6–30 years. Investors have dubbed the move “Operation Twist” because the Fed is twisting the slope of the yield curve.
This latest attempt to stimulate growth was widely anticipated by investors, but equity markets plunged following the announcement. Why the sell-off? The Associated Press tells us that “The Federal Reserve did what investors expected Wednesday—it said it would buy Treasury bonds to help the economy. But stocks fell anyway. The reason? The Fed made it clear that it thinks a full economic recovery is years away.” Are we to believe that staff economists at the Fed just broke the news to financial markets that the economy isn’t doing so hot? C’mon, these are the same staff economists who told us only weeks ago that the economic slowdown was transitory. The Fed didn’t break any news to the market. The financial markets are always way ahead of the Fed.
So why did the stock market plunge following the Fed’s Operation Twist announcement? The most logical explanation is that investors were pricing in more monetary stimulus than Mr. Bernanke delivered. It was Mr. Bernanke who came to the rescue of traders and speculators following the August Fed policy meeting. He promised to hold rates at zero and stimulate more if needed. The 2011 low in stock prices was reached August 9—the day of the last Fed meeting. Without Bernanke’s August threat of more stimulus, stock prices would be much lower than they are today. Investors were hoping for more.
What does the Fed expect Operation Twist to achieve? Bernanke & Co. want lower long-term interest rates—as if sub-2% rates aren’t low enough—and higher asset prices. The Fed believes that swapping shorter-term Treasuries for longer-term Treasuries is functionally equivalent to quantitative easing. The theory is that when the Fed prints money, it swaps a short-maturity asset—bank reserves—for a long-maturity asset—Treasury securities. With Operation Twist, the Fed is doing something similar: swapping short-maturity Treasuries for long-maturity Treasuries. The hope is that investors who sell their long-maturity Treasuries to the Fed will buy competing long-maturity financial assets (read: stocks) and drive up their prices. Sounds good in theory, but the Fed outsmarted itself here. Operation Twist is bad policy and bad economics.
Why is Operation Twist bad economics? First let’s look at interest rates. Rates are already at historic lows. A drop of another few basis points isn’t going to help stimulate the real economy. If the Fed is trying to ignite a refinancing boom, lower rates aren’t going to help. Many homeowners don’t have enough equity to refinance. Lower interest rates aren’t going to change that. And by flattening the yield curve (pushing long-term rates down in relation to short-term rates), the Fed is likely to impair credit creation—that’s negative for economic growth. This is simple economics—basic supply and demand. When you lower the price of a product, supply falls, especially when the cost of producing that product hasn’t changed, as is the case with bank loans. With its August move, the Fed flattened the short end of the yield curve. Three-month CDs now yield 11 basis points while two-year Treasury notes yield 19 basis points. There is almost no profit to be made by banks in extending short-term loans. And with Operation Twist, Mr. Bernanke is taking away the profitability of riskier, longer-term loans.
It makes one wonder if Operation Twist is not just the first step of a broader plan by the Fed.
Jeremy Jones, CFA
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