The Federal Reserve’s Operation Twist was everything it was cracked up to be, and even a bit more.
While the stock market was less than impressed with the central bank’s latest stimulus plan, the bond market was all for it.
And why not?
The Fed announced it would direct $400 billion from the sale of Treasurys of three years and less in duration and invest it in those with maturities of six to 30 years.
The total was about $100 billion more than expected and an indication that the Twist—which seeks to lower long-term borrowing costs by compressing the yield curve for government debt—was on in a big way.
“This is about as aggressive as you can be without actually expanding the balance sheet,” said Kevin Ferry, president of Cronus Futures Management in Chicago. “Will it work? Is there going to be less debt in the system or more? There’s going to be more. The Treasury’s obligations are going to come due.”
Following the news, the market for government debt jumped. The benchmark 10-year note saw its yield shrink below 1.90 percent and the long bond, with duration of 30 years, threatened to dip below 3 percent.
Though the trading was choppy at first, investors eventually sold shorter-dated notes.
In brief, the market quickly tried to front-run the Fed’s operations , which will take place between now and June 2012.
For those looking to the Fed to conduct an actual quantitative easing operation, in which, as Ferry said, the central bank tries to stimulate the economy by electronically printing money, the news was disappointing.
In the previous two versions of QE, investors reacted enthusiastically, pumping up the equities market in hopes that the Fed’s debt-buying would goose economic activity.
When the news came Wednesday afternoon confirming there would be no balance-sheet expansion, the stock market sold off—at first fairly aggressively but then paring back to somewhat modest losses.
“The big takeaway for us is: In the struggle to pass meaningful monetary policy actions that would stimulate the economy, (Fed Chairman) Ben Bernanke failed,” Jason Schenker, president of Prestige Economics in Austin, Texas, said in a note. “There is no QE3. We believe that the internal struggle within the Fed to reduce the risk of recession and deflation by engaging in further quantitative easing was resolved with this half-hearted compromise. .”
The other interesting part of the Fed’s statement was its intentions to reinvest principal payments from its holdings of debt and mortgage-backed securities from government-sponsored enterprises Fannie Mae and Freddie Mac in agency mortgage-backed securities.
That falls a bit outside the definition of a “Twist” but is indicative that the central bank is intent on keeping mortgage rates low as well.
The question for the Fed going forward is what kind of market it will find for all its longer-dated securities down the road. Bernanke and the supporting members on the Fed who approved the statement in a 7-3 vote are essentially not concerned with what inflationary pressures will be exerted by all the money printing.
“Officials point to further amelioration of commodity and energy prices following a slide from a peak, while the Fed also noted that longer-term inflation expectations remain stable,” Andrew Wilkinson, chief economic strategist at Miller Tabak in New York, said in an analysis. “You can take this as somewhat of a poke in the eye to those claiming inflationary implications of earlier rounds of quantitative easing.”
They had better be right, considering the capital-eroding effect that inflation has on longer-term bonds. Should inflation pressures ratchet up, the Fed could find itself awash in long-term debt for which there will be no market.
“They’re buying valueless securities, negative-yielding securities, and holding to maturity,” Ferry, of Cronus Futures, said. “Assuming the economy comes back, who are they going to sell them to?”
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