On August 6th, I first wrote about the Federal Reseve’s (the “FED”) future plans with a strategy known as “Operation Twist.” Since the time I first wrote about it, the strategy has become more widely known as the financial news media has promoted the idea forward.
In short, the strategy is intended to lower long term bond rates while mildly lifting shorter term note rates–in essence, the Fed would redeem money from shorter term notes and re-invest them into longer term bonds and notes (mostly 10 and 30 year yields). With this strategy, the FED can keep rates low for homeowners who want to re-finance their homes or for new home buyers which would help to lift the depressed housing industry in this country. Also, lower longer term rates would be attractive to businesses that wish to expand which in turn would help to improve the job hiring picture for Americans. Moreover, the strategy would be acceptable to those who reject the Keynsian approach of Ben Bernanke to solving the economic troubles of this country, because the FED would not be buying any additional treasuries…but rather would be simply trading shorter term duration paper for longer date ones.
All in all, this seems like a good strategy, given that the FED is now constrained by opposing political forces which do not want to see it expanding its balance sheet any further…and yet it gives the FED another tool to apply to its ailing patient, the American economy. At the same time, the FED realizes that the Fiscal Policy of this nation is in poor shape, as witnessed by the inability of Congress to come to any agreements on how the future budgets of the Federal Government should appear…and on the inability of a president to get compromise from either party…and on a presidential administration that continues to sue, counter-sue and put more regulations on anything and everything that is business. Washington is essentially in gridlock…and businesses are so unsure of the future that they are not hiring. The August Jobs Report came in at virtually zero jobs added…a very poor result in the year before a presidential election and the 3rd year of recovery from a bad recession.
So, Operation Twist appears to be the best band-aid among the few that the FED can apply without too many repercussions at this time. However, as I have continued to weigh the strategy and its potential effects, it has become apparent to the FED that inflation is on the rise, even in the government’s official reports. (Many consumers already knew inflation was on the rise…but the Fed was in denial about this, at least officially.) With rising inflation, including Bernanke’s prized measure, the core inflation rate, the effects of Operation Twist could take on a more macabre aspect.
Consider the following: with inflation rising, one would expect the longer dated treasuries (10s and 30s) to be rising in yield. However, if the FED begins to buy the longer dated treasuries, it in effect is creating an artificial rate that hides the true result of inflation. Is this partly why Operation Twist is apparently the FED’s next move? If inflation is rising, the FED may be thinking it can buy time for the economy by keeping longer term rates low, which keeps the housing market and long term corporate expansion supported (as feeble as it may seem). This is all well and good for the average American, but…
What will be the reaction of the bond market investors? If they know that inflation is rising, and yet the long bonds are not reflecting the proper yield, does this scare them away? And does this leave the FED to be the only buyer in town?
If inflation should continue to escalate in this country, and the long end of the bond market is artificially induced to be at a lower yield, does this set up the currency traders to take out their punishments on the US dollar? This is a key question in my mind. The beleaguered dollar has already suffered much…
Yet in theory, when the shorter maturities yields rise (as Operation Twist intends), this should strengthen the US dollar. Most currencies trade day to day based on short term interest rates…at least this is what is taught in beginning macro-economics courses. Yet, in this topsy-turvy world we live in these days, nothing is as it should seem. If the long bonds are being ignored by the bond market (particularly foreign investors like China) because the rates are artificially too low, does this set up a crushing blow to the dollar? You see, when our money goes overseas to buy products from places like China, Korea and and the OPEC nations, we count on some of it to get reinvested at least into our debt paper here as it has been for the past many years. But what if the foreign bond buyers decide that they have had enough of the Fed’s tricks?
…And will the dollar shorts seize on this disparity and induce more selling of US dollars? One can already see some effects in the markets…indirect bids on some US treasury auctions have dropped of late…meanwhile, gold continues to rise to new highs….sometimes violently! Indeed, gold is the one currency that no country can print at will. As the Swiss recently announced they will be printing more money to keep the value of their currency in check (and why I took profits on FXF near its all-time high–see my earllier posts), gold has now become the only currency that does not get printed…it is the only “true” currency left. And what of the dollar itself…even as many fearful investors have flocked to US treasuries of recent in a “risk off” world, why is it that the US dollar has not strengthened by much? Even against the Euro currency where money has fled the banking system over there, the widely anticipated rise of the Dollar against the Euro has not appeared. Why is that?
So, if the US dollar gets punished over a strategy like Twist, does this in turn induce imported inflation for Americans. Considering that the balance of trade is such that many products we buy come from overseas, it would seem that American citizens would be the scapegoat (once again!)…savers would be hurt. Consumers of everyday products and foodstuffs might suffer. Only those who have failed to control their spending–those with large mortgages might find some peace with this plan. Yet, the average American will be left out on the street corner as his/her own situation is eroded by runaway inflation caused by a falling dollar–possibly?
Also, Operation Twist, at least to this non-credentialed (in economics that is*) observer, is somewhat contradictory of the most recent FED strategy, which was Bernanke’s announcement to keep the discount rate at near 0% until the middle of year 2013. The contradiction is that he will allow the shorter term Treasury notes’ interest rates to rise a bit…and so what you would have would be a yield curve that starts at zero (discount rate on overnight loans to banks), then rises on the 3 month, 6 month, 1 year and 2 year paper….then perhaps flattens out a bit in the middle of the curve, then rises again toward longer dated ones…but the longer dated end of the yield curve would still be lower than it is today, especially the 30 year bonds. So, you would have banks borrowing at 0%, and able to loan out their money at higher rates, even to short term borrowers. Longer term buyers would have somewhat lower borrowing rates than today.
However, the bond investors would see that they are getting paid less on the longer term paper, even as inflation rises. This contradiction, it would seem, would cause bond buyers to look elsewhere for investments…and leave the FED to buying more longer dated paper that is not really valued correctly.
Indeed, this raises another question, (and is probably a blog for another day), as this subject is no
t relevant to this discussion…but if the FED is to buy a lot more long dated treasuries at artificially contrived (lower) rates, what happens to the FED’s balance sheet when it must sell some of this paper later? Or does the FED believe that it can hold this longer dated paper until expiration and not face the headwinds of rising inflation and a bond market that might later refuse to buy back these bonds except at much higher rates?
Operation Twist could prove to be a serious mistake for the Fed as it could load its balance sheet with greater average duration. Should inflation take hold and force up interest rates, it could cause large losses on the Fed’s balance sheet. In turn, this leaves the Fed in a position where it could not sell off assets to dampen monetary growth in an inflationary environment, thus rendering itself incapable of controlling a rampant inflation. Couple this with dollar weakness as I mentioned earlier, and one can envision a recipe for disaster!
I think this is an important issue that is not being widely addressed or even understood by most of the public, including the so-called experts; but the implications could be profound for all Americans and the world. The problem for the Federal Reserve is that every time it tries to fix a problem, it creates new problems which in turn bring this country’s finances…and its currency, closer to the brink of Armageddon.
* I do not hold any degrees in economics, but I was always a star student in high school and college economics courses. Indeed, if I could start my life over, I believe I would have pursued a degree in the dismal science. However, I do hold a bachelor’s and a master’s degree in business disciplines and have been a mid-level executive in business for a number of years.