What Another Operation Twist Means for the Markets
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"Come on let's twist again, Like we did last summer! Yeaaah, let's twist again, Like we did last year!"
– Chubby Checker
During the last half of 2020, bond yields flat lined at historically record low yields. The message was clear: Bond investors did not fear inflation. The tone changed abruptly in early January when the 10-year U.S Treasury yield rose above 1.00%. In February, five-year Treasury yields crossed 0.50%, which raised alarms for global investors.
Despite stock market trepidation over rising yields, the Fed remains calm. Some Fed members are applauding higher yields. The following four comments came from three Fed members on February 25, 2021, the day in which the five-year Treasury notes gapped higher by 25 bps:
- Jim Bullard: "The rise in bond yields is a good sign so far."
- Esther George: "Long tern yield rise doesn't warrant monetary response."
- Raphael Bostic: "I am not worried about move in yields."
- Raphael Bostic: "(The Fed) doesn't need to respond to yields at this point."
Quite often, Fed members make statements that turn out to be not true. The comments above fit this bill.
The Fed is keenly aware rising interest rates will choke off the fledgling economic recovery. The possible solution to halting rate increases and keeping the recovery rolling dates to the 1960s when Chubby Checker and the Twist were all the rage.
In this article, I dissect Operation Twist. I also look back at Operation Twist 2.0 circa 2011- 2012 and assess its effectiveness and how it impacted various asset classes.
I brought up Operation Twist a month ago in: Can The Fed Both Tap On The Brakes and Floor The Gas? At the time, I thought Operation Twist might alleviate coming irregularities in Treasury issuance.
The Twist 1.0
The Fed introduced Operation Twist 60 years ago (1961) under pressure to spur economic activity. At the time, the dollar was pegged to gold, which limited the Fed's options. Lowering interest rates would have weakened the dollar and led to the withdrawal of gold by foreign nations.
To stimulate economic activity and avoid losing gold, the Fed devised Operation Twist. Under the plan, the Fed buys longer-term securities, similar to quantitative easing (QE). However, it does not print reserves. Instead, it funds the purchases by selling shorter-term securities. Given that the Fed's balance sheet and money supply wouldn't change, it hoped the actions would not weaken the dollar.
Per the San Francisco Fed:
The Kennedy Administration's proposed solution to this dilemma was to try to lower longer-term interest rates while keeping short-term interest rates unchanged—an initiative now known as "Operation Twist" in homage to the dance craze then sweeping the nation. The idea was that business investment and housing demand were primarily determined by longer-term interest rates, while cross-currency arbitrage was primarily determined by short-term interest rate differentials across countries. Policymakers reasoned that, if longer-term interest rates could be lowered without affecting short-term yields, the weak U.S. economy could be stimulated without worsening the outflow of gold.
Let’s Twist again 2.0
The Fed revisited its Operation Twist playbook in October of 2011. This period was different from 1961 as there was no gold standard and the Fed’s balance sheet was significantly larger. As a result of QE and the financial crisis, the Fed's balance sheet surged by 200% to nearly $3 trillion from 2008 to when QE2 ended in mid-2011.
The newly held short-term Treasury securities gave the Fed sufficient ability to shift its holdings to longer maturities and encourage economic activity.
Per the Fed:
To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to extend the average maturity of its holdings of securities. The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less. This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative.
"I would be concerned if I saw disorderly conditions or persistent tightening in financial conditions that could slow progress toward our goal."
– Fed Governor Lael Brainard 3/2/21
In 2011, the Fed stated: "This program (Operation Twist) should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative."
The economy's Achilles heel is higher interest rates and the resulting "tightening in financial conditions." Despite the nonchalance of some Fed members, Lael Brainard understands the problem. She is aware higher rates will all but ensure the economy doesn't exit from recession.
On May 3, 2021, San Francisco Fed President Mary Daly took Brainard's comments a step further. She said, "the central bank could alter the maturity of its bond purchases – or even, as it has done before, sell shorter-term securities to buy longer-term government bonds in a so-called twist.’"
As interest rates rise, the odds of Operation Twist 3.0 increase. The Twist can slow or halt rate increases without altering the current $120 billion per month pace of QE. The alternative option, increasing the amount of QE, might cause rates to climb further due to inflationary implications.
The Twist allows the Fed to manipulate markets without increasing its footprint.
What Twisted and how?
Looking back at Operation Twist 2.0 (2011), we can assess how effective its actions were and how various asset classes performed. Such analysis provides some insight into how those asset classes may perform today.
The first three charts below show yields on two- and 10-year notes and the two-10-year yield curve. In the graphs, the period of Operation Twist is highlighted in gray. The green lines show the running percentage change in yields during the Twist operations. Additionally, the two-10 curve graph highlights that the curve flattened by 124 basis points during the period from when the Twist was rumored in July 2011 to its completion.
The next set of graphs use the same format to show how the S&P 500, crude oil, and gold performed during the same period.
Lastly, I show how the S&P sectors and other equity indexes performed during Operation Twist and the pre-Twist rumor period.
Operation Twist 2.0 accomplished the Fed's mission. The yield curve flattened significantly without the Fed increasing its balance sheet. Most of the flattening occurred before actual operations when the Twist was a rumor. Conversely, most equity markets and sectors rose during Operation Twist, but were uninspiring during the "rumor" period. The economy was slowing at the time; macro trends were also contributing to lower rates.
The sectors typically associated with inflation and higher rates – financials, energy, materials, and industrials – fell from the point of Twist rumors until its conclusion. Sectors benefiting from lower rates like utilities, technology, and staples did reasonably well throughout the entire period.
Most interesting, the weekly correlation between bond and stock prices from rumor to the end of operations is strongly negative, as shown below.
“Twistin' time is heeeere!”
Given the Fed's bloated balance sheet, higher yields will prompt the Fed to do the Twist. In 2011, when the Fed first hinted about the Twist, the two-10-year yield curve was 2.60%. Today the yield curve is about half of that level at 1.35%. As such, it is less likely the Twist can have the same effect.
The supply-demand equation for Treasury debt is different today. For starters, the government is running a $3 trillion deficit, about three times that of a decade ago. Offsetting the supply of debt is the Fed's monthly purchases of $80 billion in Treasury securities (the rest of its purchases are of mortgage-backed securities). In 2011-2012, the Fed's balance sheet was not growing as QE2 just ended. Further, over the next few months, Treasury issuance will temporarily be light, as I noted in the opening section.
The Fed has enough assets to flatten the yield curve significantly. The question facing investors is how other asset classes will react? Lower rates may placate rising tension in the equity markets. They may also, on the margin, boost economic activity.
Given the extremely speculative nature of markets and massive amounts of fiscal and monetary intervention, we must ask: Will investors dance with the Fed, or will they fear something is not right?
Michael Lebowitz is the founding partner of 720 Global and partner with Real Investment Advice. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics. For more information about our upcoming subscription service RIA Pro, please contact us at 301.466.1204 or email [email protected].