The Fed’s Decision: “Operation Twist”

For months, even before the end of QE2, analysts and prognosticators have been saying the Fed will have to do another QE and another, endlessly. These folks were surprised when it didn’t come last month, and predicted confidently that it would come this month especially because Bernanke extended the September meeting to two days. I said then, and I still believe it, that QE3 will come, but not as quickly as most people think (or hope).

So today, the Fed gave us, in addition to their normal pap about “downside risks” and “exceptionally low rates” forever, two new policies: (1) they will sell $400B worth of Treasurys of 3 years or shorter maturity, and buy $400B worth of Treasurys with 6 to 30 year maturity; and (2) the Fed will reinvest the proceeds when mortgages it owns are paid.

The markets became very volatile after the announcement. When the dust settled, we had S&P down 3%, every currency, including the yen, down substantially on the day (much less from the day’s highs around 3:30pm EDT), copper down hard, crude, and even gold and silver down, down, and down. Copper and the precious metals continue to sink as I write this.

Obviously, the Fed’s decision disappointed and underwhelmed market participants. It has become a cliché to say that there is a “Bernanke Put”, i.e. he won’t let stocks fall. One commenter said that today’s decision moved the Put farther out of the money.

I don’t think that the Fed cares about the stock market, in particular. I think it cares about its member banks interests, in this case their balance sheets.

The Fed might care about the stock market if it is a means to its ends, as in the following chain. If stock prices rise, then investors feel wealthier. If they feel wealthier, then they buy homes and invest in businesses and commercial real estate. If they buy and invest, this firms up asset prices. These are the assets on bank balance sheets, so firming up the prices will bolsters said balance sheets.

So today the Fed threw the stock market under the bus, or at least allowed it to go under the bus. Let’s look at what the Fed did in lieu of more outright printing.

The simpler of the two policies is: the Fed will reinvest the money it gets from mortgages that are paid or prepaid. This is nothing more than the Fed saying they will continue to hold their balance sheet at its current size. They do not want to withdraw liquidity. One theory says this paves the way for Treasury to announce a giant re-finance for everyone. We shall see.

“Operation Twist” as the financial blogosphere has been calling it is simple in its mechanics. Sell short duration and buy long duration Treasurys. I am not sure that I believe they will sell anything. They surely do not want the interest rate on the short end of the yield curve to rise, much less for the yield curve to invert! But perhaps demand is so strong that they haven’t had to manipulate short end anyways for months? I don’t know and they aren’t saying.

By plowing money into the 6-30 year maturities, they will push up bond prices there. Since the interest rate and the bond price are a see-saw, mathematically and rigidly related, this will push down the rate of interest on 6+ year bonds. I would guess that the Fed thinks that this will spur more borrowing and lending. The theory is that with lower rates, businesses will make a case to borrow for new projects (I think they have many reasons not to). And investors will be forced to take more risk to earn a decent yield. Maybe, but I remain doubtful.

It will, however, have other consequences. I predict the following:

1. The spreads between municipal or corporate bonds to Treasurys will widen. Yields on those will go down (where there isn’t growing risk of defaults as with many munis), but not as much as Treasurys will.

2. Bond speculators (is there any such thing as a genuine saver who has been buying 30-year bonds to hold for three decades??) will be rewarded with capital gains. Good for them.

3. The capital that goes to bond speculators comes out of the capital accounts of the bond issuers. It’s a zero-sum game. When interest rates rise, bond speculators lose and bond issuers gain. When rates fall, the opposite.

4. One of the banks’ (illicit) source of risk-free profits is reduced. Yield curve arbitrage, borrowing short to lend long, will become less profitable.

5. Where bond issuers have access to the markets to “roll” their liabilities, the new payments will be lower. In theory this would allow them to borrow more (which is what the Fed intends). In practice, we shall see. Certainly governments will, as there is little or no personal downside to the politicians who make such decisions.

6. Any borrowing that only makes sense because the interest rate was further reduced is, almost by definition, malinvestment. Such borrowings will not be paid back. Car buyers would do well to consider the total cost of ownership over the life of that 84-month 15% interest loan with the balloon at the end and “affordable” payments. The same is true with government and corporate borrowers: there are other considerations than monthly payment.

7. Assuming any business does borrow at the new, lower rate, it will have a permanent competitive advantage over its competitors who borrowed at the old, higher rate. The new borrower will either be able to produce the same good at lower cost (due to lower debt service) or be able to attract customers to the new restaurant, hotel, resort, cruise ship, shopping mall, etc. Customers love higher ceilings, lavish landscaping, opulent gilding dripping from the marble columns, etc.

8. Thus capital destruction will continue and accelerate.

9. The process of halving of interest rates will continue. It is just as damaging to go from 1.5% to 0.75% as it was to go from 12% to 6%.

10. Debt accumulation will continue.

11. All, of course, until it cannot continue.