With commodity prices retreating and fears of a recession mounting, an increasing number of economists and bond investors believe that Federal Reserve Chairman Ben Bernanke may signal during August 9th's Fed meeting that it will purchase Treasury securities with maturities of 10 years or greater in order to stimulate the economy. This would mark a change from the purchases during "QE2," which concentrated more on the center of the yield curve.
Call it "QE3" with a twist, as a similar maneuver was enacted during an incoming JFK administration and was nicknamed "Operation Twist" in honor of Chubby Checker's dance craze of the day. JFK and the Fed Chief in 1961 faced two issues. Like now, there was a possible recession. But for them, because of the gold standard, low short-term rates were causing a massive currency arbitrage where investors would exchange U.S. dollars for gold and move bullion en-masse over to a higher-yielding Europe. So they needed a way to keep short-term rates steady or even higher, yet lower long-term rates to stimulate the economy.
A paper written in April by the Federal Reserve Board of San Francisco on this topic has been making the rounds on trading floors as a possible template of what may be used today (link to paper here). As the paper describes, the Fed sold short term securities and bought long-term bonds, lowering long-term Treasury yields by about 0.15 percentage point, according to calculations by the authors, Titan Alon and Eric Swanson.
On April 6, 1961, a Fed release "showed a sharp increase in open market purchases of longer-dated Treasurys, including for the first time maturities longer than ten years," wrote Alon and Swanson. "The idea was that business investment and housing demand were primarily determined by longer-term interest rates, while cross-currency arbitrage was primarily determined by short-term interest rate differentials across countries. Policymakers reasoned that, if longer-term interest rates could be lowered without affecting short-term yields, the weak U.S. economy could be stimulated without worsening the outflow of gold .
The bond market is behaving like some sort of maneuver of this nature is coming. In the last week, the 10-year yield and the 30-year yield have seen the biggest moves along the curve, both dropping by 0.6 percentage point. That move accelerated during Thursday's stock market plunge.
"Long end Treasurys led the charge higher when stocks crumbled mid-morning," said William O'Donnell of RBS. "Short Treasury tenors have little room to run and the recent bull flattening has helped spur thinking that the Fed will consider blowing the dust off of Operation Twist (1961), which was designed to lower long term rates back then."
By keeping short-term rates the same or higher this time, the dollar would likely stay strong, said investors, and help Bernanke fight back against the biggest criticism of his last quantitative easing plan: the surge in commodities.
"QE3 now seems unavoidable in the context of a widening output gap in H1, a broad-based stall of employment growth and forthcoming increasing drag from fiscal policy," according to a piece by the economic team at Nouriel Roubini's research firm, Roubini Global Economics. "A significant balance-sheet expansion may be a hard sell in H2 2011, with core inflation indexes staying steady through the end of the year. That said, extending the maturity of the Fed's holdings seems more plausible, and indeed would address QE2's key shortcoming-that the program did little to counter the lengthening maturity of outstanding Treasurys."
Roubini's team is referring to another key document being passed around by traders these days, Bernanke's Semiannual Monetary Policy Report to the Congress on July 13.
"On the one hand, the possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support," said the Fed Chief before recent economic data would prove him right. "Even with the federal funds rate close to zero, we have a number of ways in which we could act to ease financial conditions further. One option would be to provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels. Another approach would be to initiate more securities purchases or to increase the average maturity of our holdings."
Other options for the Fed chief that have been suggested by traders is cap treasury rates, something not done since the 1940s. Other strategists say don't do anything, this is Europe's problem and our own easing will just dig us deeper into a whole we would have to unwind one day.
"Another Fed option is to sell puts on Treasury futures," suggested Brian Kelly of Brian Kelly Capital. "It would not take a lot of money and it would cap rates."
"But you know what would really help?" Kelly added. "The Fed could buy single-family homes."
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