The FOMC extended “Operation Twist” through the end of the year and committed to move another $267 billion of assets from its holdings of securities with maturities of 3 years or less into maturities of 6 years or more. This will reduce its portfolio of short-term securities by about 1/3 and increase its holdings of securities in the 6-years and older category to over $2 trillion, or about 75% of its total holdings of $2.6 trillion. Such a lengthening of the duration of its portfolio is indeed significant, especially when it comes to evaluating the implications of possible exit strategies that don’t simply allow for longer-term securities to mature and run off. The current duration of its assets is estimated http://www.cumber.com/content/index/duration.pdf to be about 39 basis points, which means that a parallel shift in the yield curve by that amount would exhaust the Fed’s capital if its assets were marked to market. But that isn’t the concern here. The key question is, what impact has Operation Twist had on the term structure to date and how stable has that impact been? But first some general observations on the policy decision and its context, which are best considered by looking at the changes in the FOMC’s forecasts that were released following its meeting.
FOMC participants in this June meeting significantly downgraded their outlooks for both GDP growth and unemployment. GDP growth for this year was reduced noticeably below what it was in January of this year, and this is on the heels of an increase at the April FOMC meeting. The reductions carried through not only this year but 2013 and 2014 and even to the intermediate term. Similarly, after dropping the upper bound of the central tendency for unemployment to below 8 percent in April, the new forecast has 8 percent as the lower bound for the central tendency. A similar pattern held for the 2013 forecast. Additionally, the central tendency for 2014 widened significantly. What this says – and markets reacted accordingly – is that the FOMC is much more concerned now about the likely performance of the real economy than it was in April.
Given the forecasts, it is clear the committee had to do something, if only to maintain credibility. But what to do? Simply modifying the statement language would not prove to be credible upon release of the minutes detailing the actual committee discussions and the concerns expressed about the risks to the expansion. Moving to another round of quantitative easing might suggest panic over both the US economy and the risks emanating from Europe. To this one might also add uncertainty about the exact nature of the benefits to growth and employment of another round of quantitative easing, and also the risk that strong action might be interpreted as a political move during an election year. Chairman Bernanke has opined on the former issue several times. So, simply extending Operation Twist was the least-cost way of “doing something” while not expanding the Fed’s balance sheet, keeping its powder dry, and only incurring marginal additional risk, once exit from its extremely accommodative stance becomes necessary.
Now the question remains as to what impact the move is likely to have on interest rates and the rest of the economy. To investigate the first of these two issues, we compare the daily yield spreads across the maturities, as reported by the US Treasury (http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield ) over the course of Operation Twist, which was announced after the September 2011 FOMC meeting and commenced on October 3rd. The first chart http://www.cumber.com/content/special/history1.pdf shows the term structure for several maturities, as reported by the Treasury. The baseline is the term structure as of 10/3/2011, the date that Operation Twist actually began. Between September 21, following the program’s announcement, and the actual start of the program, the spread for maturities out beyond 5 years decreased by a maximum of 25 basis points but then subsequently varied above and below the baseline across time.
The spread history for the longer maturities is more easily seen in the second chart http://www.cumber.com/content/special/history2.pdf. In particular, spreads for maturities 7 years and longer were consistently above what they had been after the program was initiated. The seven-year spread only turned negative for three short intervals, before turning consistently negative in early May 2012. For the longer maturities, the spreads never turned negative until the very end of May 2012.
During May, longer-term spreads began to decline and fell below the baseline in a sequential and regular way. For example, the 7-year dropped below the baseline and stayed there, beginning about May 5th. The 10-year didn’t fall below the baseline until May 14th,and the 20-year followed a day later. The 30-year didn’t exhibit this pattern until May 30th.
So, far from long-term rates being lowered over most of the Operation Twist period, long term rates initially rose and stayed above the baseline. Interestingly, rates on the maturities the Fed was selling fell slightly below where they were on October 3rd, while rates on the maturities the Fed was adding to its portfolio actually rose above the October 3rd baseline. Long-term rates didn’t drop below the baseline until seven months after the program began. This pattern suggests a combination of a sequential reach for yield and a flight to safety by investors, based upon uncertainty about the US economy and developments in Europe.
What does this tell us about the likely term structure going forward under the extended Operation Twist? Given that investors and the Fed have finally bid up prices on longer maturities and lowered rates, it is not likely that the previous pattern of variable spreads, noted above, will reappear. Instead, we look for a continued modest drop in longer-term rates, which will be reinforced by the continued flight to quality by European and other investors seeking safety. This time rates will be lower, and will likely remain extremely low across the term structure, until the Fed reverses the lengthening of the duration of its holdings. Moreover, at the end of the year, stopping the program will not change the duration of the Fed’s portfolio or the term structure.
Will the low rates induce corporations to invest, will banks respond by seeking yield on loans and nongovernmental securities and will consumers borrow and begin to spend? That, of course, is the Fed’s gamble; but there is the risk that continued uncertainty will negate this portfolio-balancing approach to stimulating the economy. The data suggest that uncertainty and perceived risks were as important or more important than Fed purchases and sales in affecting the term structure and spreads.