The Federal Reserve Extends Operation Twist

The Wall Street Journal – Fed Extends Operation Twist
U.S. Federal Reserve officials signaled heightened worries over the economy on Wednesday, extended a program shifting their holdings toward longer-term securities through the end of the year and said they were “prepared to take further action” if needed. The central bank stopped short, however, of immediately taking the more aggressive step of launching a new bond-buying program to bolster the U.S. economic recovery. “The Committee is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability,” the Fed said in its statement. Eleven out of 12 Fed officials voted to keep the central bank’s easy-money policies in place. The Fed has said since January that it plans to keep short-term interest rates at “exceptionally low levels” at least through late 2014. The central bank has held short-term rates near zero since December 2008 in hopes of spurring spending and investment.

Bloomberg.com – Caroline Baum: The Fed Is Running Out of Room to Twist
The Federal Reserve announced at the conclusion of today’s meeting that it will continue its maturity extension program, known as Operation Twist, through the end of the year. This time it plans to buy $267 billion of notes and bonds with maturities of six to 30 years, and to sell an equivalent amount of short-term bills and notes. Why so small? The current program, which ends June 30, totaled $400 billion. Answer: The well is running dry. After various rounds of bond purchases, the Fed owns only $175 billion of securities maturing in three years or less, according to Jim Bianco, president of Bianco Research in Chicago. By his estimates, that amount will rise by $100 billion by year-end. At least we won’t have to contemplate Operation Twist 3.0 (4.0 if you count the 1961 effort). And that’s a good thing, because fiddling with the maturity of its portfolio is not the same as expanding its balance sheet. And based on today’s reaction — the 10-year Treasury note spent 10 minutes in positive territory after the 12:30 p.m. announcement — the market may not give Bernanke the lower long-term interest rates he wants.

The Financial Times – Mohamed El-Erian: The Fed’s second best solution
Pity Ben Bernanke and his colleagues on the Federal Reserve’s main policymaking committee. Once again they felt compelled to do something to be seen as countering a renewed slowing of the domestic economy that is compounded by a deepening European crisis and less buoyant emerging economies. But in continuing to act on its own, all the Fed will do is buy some time that will again be wasted by the country’s politicians. Meanwhile, collateral damage will mount, making the next policy steps even more excruciating…While the Fed has been able to normalise market functioning and boost valuations, it has repeatedly failed to deliver on its desired economic outcomes. Unfortunately, there is little to suggest that things will be any different this time around.

Comment

Yesterday we argued that the Federal Reserve would not extend Operation Twist because the $175 billion in 0- to 3-year securities on their balance sheet was not enough to implement a meaningful operation.

Despite this, Bernanke extended Operation Twist through the end of 2012 for an additional $267 billion.  So, how can the Federal Reserve sell $267 billion of 0 to 3 year securities when they only own $175 billion?  It depends on how you define “three-year securities.”

What Is A Three-Year Security?

We defined 0- to 3-year securities as all securities maturing before June 30, 2015.  Using this definition, the Federal Reserve was expected to have $175 billion of securities between 3 months and 3 years on June 30.

Since the Federal Reserve extended Twist until December 2012, they must be defining a “three-year note” as any security that has a maturity of three years or less as of December 31, 2012 .  Under this definition, the Federal Reserve would have about $295 billion of Treasuries less $30 billion of securities that mature before December 30, 2012.  Net them together and the Federal Reserve would have $265 billion of securities they can sell before December 31.  This is a rounding error difference from the Federal Reserve’s $267 billion estimate.

This also means when Operation Twist is done, the Federal Reserve will have no Treasuries that mature before 2016.

Will The Market Have A Plumbing Problem?

When Operation Twist is over and the Federal Reserve owns no securities that mature in less than three years, the market could have a plumbing problem.  The next story explains it well.

Liquidity Problems Likely in Twist Extension: Cloherty
2012-06-21 12:09:25.260 GMT
By Elizabeth Stanton

June 21 (Bloomberg) — Fed is likely to have to “adjust the mix of its purchases well before the end of the year, possibly by adding MBS to the purchase mix,” RBC strategist Michael Cloherty said in an emailed response to questions.

* Recent offer-to-cover ratios in 8-to-10-yr and 10-to-20-yr purchase operations have been low
* Last three operations in 8-to-10-yr sector were covered 1.84 to 1.99 times vs 2.77 average in six previous
* Most recent purchase in 10-to-20-yr sector covered record low 2.11 times vs 3.23 average in previous three
* Fed reduced the size of its purchase operations in the 20-to-30-yr sector in Feb. (to $1.5b-$2.25b range from $2.25b-$2.75b) after offer-to-cover ratios declined
* Bank of England also in Feb. “had to shorten the maturity mix of its QE purchases because long-end liquidity had deteriorated”
* Adjusting mix of purchases to address liquidity problems

Source: Bianco Research