September 28, 2011

Operation Twist Explained (and why this "stimulus" program is going to hurt individuals just like the previous ones)

Operation Twist

Operation Twist is supposed to drive down the interest rate on 10-year bonds. (The Fed buying the 10-year bonds increases the demand for them, and as demand increases for bonds, their price goes up and their yields go down). However, just like the other Fed tampering – QE and QE2, this operation will end up by perversely screwing individuals, but helping the government. Let’s recap Operation Twist:

1. The Fed already owns about $1.65 trillion in bonds, purchased over the past few years in an effort to bring down medium- and long-term interest rates (QE and QE2).

2. A lot of those bonds — hundreds of billions of dollars worth — are medium-term bonds, which come due in the next few years.

3. Interest rates on medium-term government bonds are already near zero.

4. The Fed will sell some of those medium-term bonds, and use the proceeds to buy longer-term bonds — such as 10-year Treasuries.

But the Fed’s flattening of the yield curve through Operation Twist will destroy the banking system’s incentive to lend money by reducing the opportunity for banks to leverage a positively sloped yield curve! Our banks aren’t lending money out to any except the very best of credits the way it is. We are taking a bad situation and making it worse. Ah, but not every party is worse off.

Currently, the yield to maturity on Treasuries maturing in more than 10 years is 2.73%; the yield on Treasuries maturing in less than one year is 0.077%. If the Federal Reserve buys the longer-dated Treasuries, it will take the Treasury’s coupon payments and reinvest them in housing (mortgage securities). $1.25 trillion was spent in this market during QE1 between March 2009 and March 2010. Any profits on the deal go back to the Treasury at the end of the fiscal year.

Since Operation Twist involves selling the short end and buying the back end of the yield curve, it will not expand the Federal Reserve’s balance sheet. So who is winning and who is losing in Operation Twist?

The ratio of interest to GDP had been declining for the better part of two decades before ticking higher in the second quarter. This trend has been the mirror opposite of the ratio of public debt to GDP; that number has exploded higher and neither Congress nor the administration appears to have any clue how to reverse the trend. But our government can service its debt more easily by driving its interest rates lower. They are going to end up with lower borrowing costs on its bloated and unmanageable debt. And something tells me that will find some loquacious way to tell the public that they’ve actually now effectively increased their borrowing capacity. Disgusting. One more thing, start thinking about what is going to happen when interest rates increase. That’s right – it’s going to cost more money to service the outstanding government debt – and further increase the federal deficit without any additional new spending programs.

Graphs courtesy of Howard Simons

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