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Easy Street

Operation Twist… in the wind?

Heidi Moore Sep 21, 2011

The Federal Reserve finally confirmed Wall Street’s giddiest expectations today by enacting Operation Twist.

If Operation Twist doesn’t strike you as the next James Bond sequel, you’re right. It’s the Fed’s program to sell off its short-maturity Treasury bonds — like 3-year bonds — and buy up longer-maturity ones, like 10-year and 30-year bonds. Since mortgage rates are based on the 10-year Treasury bond, Operation Twist’s intent is to ease some pressure on the housing market. Actually, that’s been the intent of all of the Federal Reserve’s “quantitative easing” programs — to bring down interest rates to fight deflation and spur growth in the economy.

But, there are skeptics. Take Peter Boockvar, a strategist for Miller Tabak, who made some good points in a note he just sent out to clients. Boockvar’s main complaint – and it’s a good one — is “why is this time different?” We’ve had record-low interest rates and the economy is still slow-growing to the point of stagnation, as the Fed itself acknowledged today. Plus, there are 19 million Americans out of work.

Here’s Boockvar’s reaction. The “FOMC” here is the Federal Open Market Committee, which is the Federal Reserve group that decides on interest rates and other policy changes. I put what I thought was Boockvar’s most interesting comment in italics below.

The FOMC again has moved to cheapen the cost of money still waiting and hoping for a different result. If only the cost of money was the impediment to growth. They announced its intent “to purchase, by the end of June 2012, $400b of Treasury securities with remaining maturities of 6 yrs to 30 yrs and to sell an equal amount of Treasury securities with remaining maturities of 3 yrs or less. This program should put downward pressure on longer term interest rates and help make broader financial conditions more accommodative.” They will also continue its reinvestment of MBS principal payments.

On the economy they said growth “remains slow” using similar wording as they did in Aug and added “there are significant downside risks to the economic outlook, including strains in global financial markets.” They also remain sanguine on inflation as they always seem to be. Again, [Fed regional presidents] Fisher, Kocherlakota and Plosser did not support additional policy accommodation at this time. Bottom line, the FOMC gave the market exactly what was expected still believing in their monetary powers to cure the economic ills that ail us.

When you misdiagnose the disease (hangover from too much borrowing/debt) however, you give the wrong treatment (to induce more borrowing/debt) and the Fed continues to perpetuate this and they wonder why the medicine doesn’t work. Refinancing is great but that doesn’t extinguish debt, it just alters its terms. We need to eliminate debt and encourage savings.

The key word here is “deleveraging.” It sounds complicated, but it really just means “reducing debt.” Leverage, to Wall Street, means debt. Think of “leveraged buyouts,” which are just the technique of buying a company by using lots of debt.

American households have a lot of debt. In fact, many have more debt than they have income – the result of years, if not decades, of piling on auto loans, credit cards, to-the-hilt mortgages, home refinancings and student loans. As of August, the Fed said that American households have $11.4 trillion of debt — which is down from the $12.5 trillion peak in 2008, but it’s still not enough of a drop, even though, as CNN Money pointed out in August, “American households have been paying down their debt slowly for nine of the last 10 quarters.” The operative word there is “slow.”

The Fed believes that lower interest rates will in some way spur the economy, and help Americans reduce their debt by paying lower interest on the considerable debt they owe.

But Guy LeBas, a fixed-income strategist for Janney Montgomery Scott, is as skeptical as Boockvar is about how much the Fed can really hope to accomplish. In a note to clients today, LeBas implied that the Fed’s move is nothing more than a gimmick designed to make people feel better rather than actually fixing the economy: “we view this latest policy as an attempt on the part of the Fed to bluff their way to better economic conditions by convincing consumers and the markets that low rates will have a big impact, despite little evidence. With the high dependency on psychology with the FOMC’s latest move, we might as well call the whole thing Operation Twist and Shout.”

LeBas said the problem with the economy is indeed psychology, and indicated that irrational fears don’t usually respond to facts: “Consumers aren’t spending and businesses aren’t investing because of a culturally-embedded fear of the future, exacerbated by the crisis du jour attitude, and lower interest rates can’t change culture.”

He added, “We don’t expect this twist to have a big economic impact, as the US’ issues are a lack of inspiration, not interest rates.”

And now we come to another operative word: lack of inspiration. Ben Bernanke, a proponent of Operation Twist, seems to have pushed it through the FOMC even though three of the Fed presidents rejected it on the grounds that Twist would not do enough for an economy in as dire straits as we are. The economist Justin Wolfers, who I debated today on Twitter, noted sagely that “most economists want more stimulus than just Operation Twist.” (Wolfers, unlike the others I’ve quoted here, supports Operation Twist and the Fed’s stimulus plans.)

Traders in the stock markets — long thought to be Bernanke’s giddiest and most enthusiastic audience for any attempt to cut rates- seem to agree. Instead of going up after the FOMC announced Operation Twist, the Dow Jones Industrial Average actually tanked by nearly 200 points. The S&P fell 30 points, or 2.5%. The research firm Markit predicted this morning that the market wouldn’t rally on Operation Twist because “it has been priced in by the market,” meaning everyone already expected this kind of stimulus, so it lost its punch.

Of course, in this last-ditch economy, Operation Twist can’t hurt — especially because it calls for relatively little meddling by the Fed. LeBas said in his client note that Operation Twist would have a far lighter impact than another full-blown round of quantitative easing: “That one fact, the idea that negative outcomes are less likely from Operation Twist than from QE3 may be overlooked by the Fed’s perennial detractors, but, from our point of view, is a key reason why it’s hard to disagree with the Fed’s action, even if the benefits are debatable.”

The Fed’s been piling on the stimulus — as Guy LeBas noted today, “This Operation Twist is the fourth extraordinary measure designed to support the US economy launched since 2008.” So the real question is not whether Ben Bernanke and the Fed are doing enough – it’s why Congress isn’t doing more.

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