In everyday conversation, the term twist is not usually associated with positive outcomes. When someone is looking to mislead, they often twist the facts. When someone tells a joke in poor taste, we say they have a twisted sense of humor, and when a football player twists their leg, arm, or neck, play stops and they usually end up out of the game.
At the end of the third quarter, the Federal Reserve embarked on its latest effort to lower interest rates and spur lending in the economy in a plan that has come to be known as â€˜Operation Twist.â€™ In a nutshell, the purpose of Operation Twist is to take $400 billion of its existing US Treasury portfolio and shift out of short-term maturities and into long-term maturities. While the Fed has been accused of debasing the dollar and printing money in its prior efforts to jolt the economy back on track (QE1 and QE2), what makes Operation Twist unique and more palatable to these critics is that it will have zero impact on the size of the Fedâ€™s portfolio. All of the purchases of long-term securities will be offset by equal sales of shorter term maturities.
In the Fedâ€™s own words, Operation Twist â€œshould put downward pressure on long-term interest rates and help make financial conditions more accommodative. In doing so, this action will support a stronger economic recovery and help ensure that inflation over time is at levels consistent with the Federal Reserveâ€™s mandate to foster maximum employment and price stability.â€1 The key word in this statement is should. While nobody doubts that the Fed has good intentions with Operation Twist, the fact is that what is often good in theory does not always play out according to plan in the markets.
Assuming that Operation Twistâ€™s intended purpose of lowering long-term US Treasury rates is successful, the problem is that most Americans and small businesses cannot even borrow at anywhere close to the rates where Treasuries are trading. For example, in the housing market, even though overall mortgage rates are down, contract cancellations on existing homes sales in August doubled to 18% from 9% a year ago.
Conditions in the corporate bond market are similarly tight. Take the high yield credit market for example. In the chart below, we compare the change in the yield on the 10-Year US Treasury to the change in High Yield Credit Spreads (spread between junk rated bond yields and 10-year US Treasury). As shown in the chart, although Treasury yields are falling, spreads on high yield debt are rising at just as fast, if not at a faster rate.
In order to get an idea of how high yield bonds are trading, in the accompanying chart we added the spread on high yield bonds to the yield of 10-year US Treasuries. In early August, spreads blew out just as the US saw its AAA credit rating cut by S&P. Since then, spreads have been essentially range bound at around 9.5%. That is until the last week.
Coincidentally, just as Operation Twist was formally announced, yields on high yield debt actually broke out of their recent range and are now well above 10%. If the Fedâ€™s intention is to lower overall long-term interest rates instead of just Treasury yields, as of now, it isnâ€™t working.
Even within the Treasury market, there is no guarantee that Operation Twist will even achieve its stated purpose of lowering long-term rates. Based on the results of prior Fed plans to lower long term interest rates, success has been, to put it diplomatically, minimal. In the chart below, we show the yield on the 10-Year US Treasury over the last three years. The red dots in the chart indicate Fed meetings where the statement indicated that the Fed would purchase US Treasuries. In each case the timing of the announcement coincided with a shortterm low in the yield on the 10-year Treasury.
In March 2009, the Fed announced $300 billion in US Treasury Purchases (QE1) when the yield on the 10-year was at 2.53%. In less than three months, the 10-year yield rose by 141 bps. In November 2010, the Fed formally announced its QE2 program of $600 billion in Treasury purchases when the yield on the 10-year was at 2.57%. Once again, over the ensuing three months, the yield on the 10-year widened by 115 bps. In each of these two periods, the yield curve widened following the Fedâ€™s announcement, which was a positive for Financials.
While recent purchases of long-term US Treasuries by the Federal Reserve have had mixed results, the strategy being employed by Operation Twist is by no means new, as it was used back in 1961. Back then the Federal Reserve worked in conjunction with the Kennedy Administration to lower long-term rates, but even here the program had mixed results in the Treasury market.
The chart to the right shows the yield on the 10-Year US Treasury from February 1961 through the end of 1964. As shown, at the time of the announcement, the ten-year was yielding 3.84%. By the end of 1965 when the policy was completely phased out, the yield on the ten-year was 4.65%. While there were certainly a variety of factors at play behind the move in interest rates, even the Federal Reserve itself has stated that the impact on longer-term Treasury yields amounted to â€œabout 15 basis points.â€2
Even if the stated goal of Operation Twist is successful and long-term interest rates do see further declines, one often overlooked group of Americans who will be adversely impacted are savers, and this comes at a time when more Americans than ever are moving from the category of net spenders to savers.
The chart below compares the population breakdown of the United States by age in 2000 versus 2009. As we all already know, the chart provides a sobering reminder that Americans are not getting any younger. In the span of under ten years, the percentage of the US population over the age of 50 has increased from 27.3% to 31.3%, making it the fastest growing segment of the population. These Americans are at the point in their lives where safe fixed income investments should make up a significant portion of their investable assets. With rates where they are, however, a more apt description may be â€˜fixed with little income.â€™
The Fed hopes that by lowering interest rates on less risky assets like US Treasuries, investors will move further out the risk curve in a reach for yield. Not only is this an endorsement of the type of risky behavior that helped to cause the credit bubble in the first place, but it is not even guaranteed to work. In fact, the argument can be made that when investors are earning zero to little income on their safest investments, instead of embracing risk they will become even more risk averse. To understand this, just watch any football or baseball game. Look at any team after they blow a big lead and are only up by a run or two. Inevitably, they always seem to tighten up and take less risks on the field.
It is not just savers who are likely to be negatively impacted by Operation Twist. Perhaps the most puzzling aspect of Operation Twist is that although the idea of lower longterm interest rates is positive, a flatter yield curve (smaller difference between short and long term interest rates) is widely considered to be a negative for economic growth. Historically, steep yield curves have been indicative of strong economic growth, while flat to inverted yield curves are a precursor of slower growth, or even recessions. In describing the yield curve, the Federal Reserve Bank of New York has said that â€œit is simple to use and significantly outperforms other financial and macroeconomic indicators in predicting recessions two to six quarters ahead.â€3 Why then would the Fed want to manipulate the shape of the yield curve to a shape which in the past has been indicative of slower economic growth?
Banks are even less likely to embrace the prospects of the flatter yield curve. Far and away the biggest loser this year has been the Financial sector, which was down 26% on the year through the end of the third quarter. Whether itâ€™s the onerous regulations of Dodd-Frank, continued weakness in the housing sector, overcapacity in the industry, potential exposure to European debt, indirect pressure of the shorting ban in European equities, the weak economy or something else, it seems as though whatever could go wrong in this sector has. Now comes Operation Twist which only piles on to the woes for the sector.
The chart below compares the performance of the S&P 500 Financial sector over the last year to movements in the yield curve (spread between 10-year and 3-month treasury yields). As shown, the two have moved in lock step with each other. From September of 2010 through February of this year, the yield curve steepened and Financials rallied. On February 8th, the yield curve peaked at 360 basis points (bps), and within two weeks, the Financial sector peaked as well. Since then, the yield curve has flattened and Financials have been flattened!
Now that the policy of Operation Twist is underway, prior experiences with a similar open market operation in 1961 as well as the more recent programs of QE1 and QE2 would suggest that whatever effect the current program will have has more than likely already been priced into the market. In terms of its impact on the economy and financial markets, Operation Twist is unlikely to be the panacea that the Fed and some of the more optimistic forecasters anticipate that it will be. In fact, the continued accommodative policies of the Federal Reserve may even be acting as a roadblock to economic growth as it takes the burden and spotlight off Washington politicians to tackle the serious issues facing economic growth. Elevated interest rates are not the number one issue facing economic growth in the United States. The number one issue is elevated uncertainty, and until uncertainty begins to decline, credit and liquidity will remain frozen.
As usual, my team and I are only a phone call away should you wish to discuss these or other financial planning and investment matters.
1 Federal Reserve Maturity Extension Program and Reinvestment Policy (http://www.federalreserve.gov/ monetarypolicy/maturityextensionprogram.htm)
2 Titan Alon and Eric Swanson, â€œOperation Twist and the Effect of Large-Scale Asset Purchases,â€ FRBSF Economic Letter, 4/25/11.
3 Arturo Estrella and Frederic Mishkin, â€œThe Yield Curve as a Predictor of U.S. Recessions,â€ Current Issues in Economics and Finance, June 1996.
This market commentary is an advertisement and was written and produced by Michael W. Conway of Summit Financial Resources, Inc., 4 Campus Drive, Parsippany, NJ 07054. Tel: 973-285-3600, Fax: 973-285- 3666 with assistance from Bespoke Investment Group, LLC . Indices are unmanaged and cannot be invested into directly. The investment and market data contained in this newsletter is not an offer to sell or purchase any security or commodity. Standard & Poorâ€™s 500 Index (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. Past performance does not guarantee future results. Information throughout this Newsletter, whether stock quotes, charts, articles, or any other statement or statements regarding markets or other financial information, are obtained from sources which we, and our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. Neither we nor our information providers shall be liable for any errors or inaccuracies, regardless of cause, or the lack of timeliness of, or for any delay or interruption in the transmission thereof to the reader. Opinions expressed are subject to change without notice and are not intended as investment advice or a guarantee of future performance. Consult your financial professional before making any investment decision.