Thursday, 21 June 2012

The Fed and the Market: Operation Twist Is Extended

The latest Federal Reserve intervention, Operation Twist, which was set to expire at the end of next week, has now been extended through the end of the year. We've seen several bouts of aggressive Fed attempts to manage the economy following the collapse of the two Bear Stearns hedge funds in mid-2007 about three months before the all-time high in the S&P 500.
Initially the Fed Funds Rate (FFR) underwent a series of cuts, and with the collapse of Bear Stearns, the Fed launched a veritable alphabet soup of tactical strategies intended to stave off economic disaster: PDCF, TALF, TARP, etc. But shortly after the Lehman bankruptcy filing, the Fed really swung into high gear. The FFR fell off a cliff and soon bounced in the lower half of the 0 to 0.25% ZIRP (Zero Interest Rate Policy), now in its fourth year.
If a picture is worth a thousand words, this chart needs little additional explanation — except perhaps for those who are puzzled by the Jackson Hole callout. The reference is to Chairman Bernanke's speech at the Fed's 2010 annual symposium in Jackson Hole, Wyoming. Bernanke strongly hinted about the forthcoming Federal Reserve intervention that was subsequently initiated in November of 2010, namely, the second round of quantitative easing, aka QE2.


The latest major strategy, Operation Twist, will run through December 2012. By the end of the program, the Fed will have sold in the neighborhood $667 billion of shorter-term Treasury securities and using the proceeds to buy longer-term Treasury securities in an effort to lower interest rates. The original Twistwas set at $400B with the additional of $267B during the extension.
Here is the key excerpt from the FOMC statement:
The Committee also decided to continue through the end of the year its program to extend the average maturity of its holdings of securities. Specifically, the Committee intends to purchase Treasury securities with remaining maturities of 6 years to 30 years at the current pace and to sell or redeem an equal amount of Treasury securities with remaining maturities of approximately 3 years or less.
Details on the extension purchase specifics are available here on the Fed's website.
With the extension of Twist, it's impossible to make a definitive pronouncement on the success of this strategy for lowering interest rates. Changes can be sudden in this global atmosphere of economic unrest, and the volatility in markets around the world is a bit nervous-making. According to the Freddie Mac survey, the 30-year mortgage rate has fluctuated between 4.22% and 3.83% since the first week in September, but the most recent average is 3.71%, just fractionally off the all-time low of 3.67%. Here is a snapshot of selected Treasury yields and the 30-year fixed mortgage (excluding points). At this point, the Fed seems to have had some success with "Twist", but the extension suggests more serious financial illness than the initial prescription could relieve.
The past three years have been an exciting time for many professional traders and their seasoned amateur counterparts. And it's been a dream-come-true for institutional HFT (high frequency trading) with computerized algorithms. Of course, there have been perils, even for seasoned pros. Thebankruptcy of MF Global is a grim reminder. And now we have the travesty of JPMorgan's trading strategy as a follow-up.
On the other hand, savers — those benighted souls looking for income from CDs, Treasury yields, and FDIC insured money markets — have had a rude introduction to the new reality, one that will apparently be with us for a very long time.

Addendum: Here is a longer historical perspective on Federal Reserve management of the Fed Funds Rate and the behavior of the 10-year Treasury yield.


See also my recent overview of the economists' forecasts for the future of the 10-year yield in the June WSJ survey.


As we can readily see, some economists are not convinced that yields will remain in the basement for the duration of the Fed's putative ZIRP timeframe. It will be interesting to compare this last chart with one for next month's survey, which will incorporate the reality of the Twist extension.

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