The Fed’s “Operation Twist”

23 September 2011

The US Federal Reserve has launched a US$400 billion (A$405 billion) stimulus program known as “operation twist” – an attempt to drive down long-term interest rates and boost the flagging US economy.

“Operation Twist” works like this. The Fed now owns US$1.65 billion of US government bonds after two rounds of asset buying under its program called ‘quantitative easing”, when it bought more US debt to inject liquidity into the economy. But the US economy is stalling and the Fed is not yet planning more asset purchases that would expand its balance sheet. The bonds it already owns will mature at different times – between one and 30 years. The Fed plans to sell some of its short-dated bonds in order to buy longer-dated issues. This will be a net stimulus to the economy and support financial markets, without expanding the Fed’s balance sheet.

It’s hoped that “Operation Twist” will depress the yields on longer-dated bonds, in theory flattening the yield curve – 30% of the purchases will be in the 20- to 30-year range. The Fed wants to encourage banks to make longer-term loans, such as mortgages to home buyers and loans for small businesses.

The Fed’s policy-setting committee (the one that sets interest rates and controls money supply growth) made a statement on Wednesday after its two-day meeting that further unorthodox stimulus is under consideration.

In addition to lengthening the maturity of its bond holdings, the Fed surprised investors by saying it will reinvest the payments from the maturing mortgage-backed securities it owns back into similar securities to support the mortgage market.

The Fed’s intention here is to boost the housing sector and, in turn, the broader economy. The Fed recognises that a modest decline in house prices can be self-reinforcing. (House prices fall, delinquency rates rise, banks lend less, the supply of buyers declines, the number of foreclosures remains high and new construction falls.)

It’s the bigger picture that is worrying markets: the eurozone debt crisis, the possibility of a US recession and a hard landing in China. As the Fed’s latest action won’t solve these issues, it is not a game-changer.

Trevor Greetham, the Director of Asset Allocation at Fidelity, says the Fed has opted not to expand the size of its balance sheet for the moment. “It may take evidence of a deeper economic slowdown and a fall in commodity prices for the Fed to act with greater force,” he says.

How have markets reacted?

Equity markets reacted negatively to the Fed’s gloomy outlook for the US economy, which talked of “significant downside risks”; this has been accompanied by a sharp downward revision of global growth in an IMF report this week.

The MSCI World Index dropped 4.2% yesterday in US dollars. In the US, the S&P 500 Index lost 3.2% on Thursday, to extend its decline since April 29 to 17%. In Europe, the Stoxx 600 Index shed 4.6%.

Ten-year US Treasury notes had largely priced in the Fed’s latest actions, but yields on 30-year US Treasuries fell below 3% on Thursday from 3.2% at the start of the week.

This latest action from the Fed offers more support to bonds than equities. But equity investors should not panic given that a gloomy outlook has already been significantly priced into shares.

Indeed, there is value to be found if patient investors are willing to stomach a little short-term volatility and take a long-term view. Allocating to high-quality, high-yielding shares (and avoiding value traps) could help weather the current storm and deliver good total returns. Equity yields are now attractive.