Will The Federal Reserve Extend Operation Twist? We Say No

Bloomberg.com – Fed Seen Twisting to Risk Management to Spur U.S. Growth
Federal Reserve officials must choose this week between their best estimates and their worst fears of what will happen to the U.S. economy. Policy makers will bring new forecasts to their June 19-20 meeting and probably will mark down their April central-tendency estimate for growth of 2.4 percent to 2.9 percent this year. Lurking in the background is the risk of increasing financial stress in Europe and stubbornly high U.S. unemployment that has remained above 8 percent for 40 consecutive months. That insurance may come in the form of extending Operation Twist — which JPMorgan Chase & Co. and Jefferies & Co. predict — or an even more aggressive response if Fed officials see high costs in a slowdown of U.S. growth. The $400 billion program, which was announced in September and ends this month, involves selling short-term debt and buying longer-term bonds. The Fed has about $190 billion of short-term maturities left to continue Operation Twist for another three months, based on calculations by Nomura Securities International Inc. The firm’s forecast is for no extension at the June meeting, with both Chairman Ben S. Bernanke and the Federal Open Market Committee probably indicating they could take additional easing steps, such as outright bond purchases, if economic circumstances warrant.An extension would fit a forecast that says the U.S. economy will avoid a disaster scenario of rising unemployment and rapidly decelerating inflation. The Fed’s decision June 20 at 12:30 p.m. New York time could be more aggressive than investors expect if policy makers decide their confidence in their own forecasts is low and want to do something extra to lean against a worst-case scenario, said Vincent Reinhart, chief U.S. economist in New York at Morgan Stanley.

MarketWatch – Fed expected to twist again
The Federal Reserve is likely to extend its Operation Twist program at the end of its two-day meeting on Wednesday, a growing number of Fed watchers said over the weekend.
Michael Gregory, senior economist at BMO Capital Markets, said more and more economists were jumping on the “bandwagon” of an extended Twist. The move would serve several purposes, but would mainly show the Fed’s resolve to act and help shore up confidence, said Millan Mulraine, economist at TD Securities.

The Financial Times- Fed’s hand could see it Twist again
Use of the Fed’s balance sheet tools would depend on how big an effect it wanted to achieve. An extension of Operation Twist, when the Fed sells Treasuries that are close to maturity and buys those with longer to run, is regarded as viable and lower-risk but there is a limit on the amount that can be done. There is no limit on the scale of QE3 but the hurdle to launching it remains high, not least because of the danger of a political backlash, leading to perverse results by undermining the credibility of Fed policy.

Comment

As we noted earlier this month:

Extending Twist is a limited option, as the Fed will have only about $175 bn of short-dated Treasuries (3 months to 3 years) in its SOMA portfolio on June 30. That would allow two to perhaps three months of further twisting at the current pace — i.e., into September. That does buy some time, but the Bernanke Fed has not been one to go for half-measures or small steps since the crisis began. If the outlook warrants more easing, we still see QE3 as the most likely tool chosen.

We still believe this is the case.

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Source: Bianco Research