Monday, September 19, 2011

No need for Operation Twist

Those who look for another Operation Twist are likely to be disappointed, because today's problems have nothing to do with the shape of the Treasury yield curve.  


3-mo. T-bill yields are zero, and gold is trading close to all-time highs in both nominal and real terms. These are classic signs that the world has an intense desire for safety.

10-yr Treasury yields of 1.9% reflect the market's belief that the outlook for U.S. growth is dismal if not downright depressing. It is also likely that 10- and 30-yr yields have been depressed of late because the market believes that another round of quantitative easing and/or an "Operation Twist" (in which the Fed would step up its purchases of longer-term Treasuries and/or lengthen the duration of its Treasury holdings, in order to reduce long-term yields and thus stimulate the economy) is imminent; i.e., the market is "front-running" expected Fed purchases.

Very pessimistic growth expectations and strong Operation Twist expectations have combined to flatten the yield curve by almost 100 bps since July. But the curve is still about as steep as it has ever been in the early years of previous business cycle expansions. A steep yield curve has never been an obstacle to growth before—indeed, recessions almost always follow very flat or inverted curves—so why should Operation Twist be so urgent or necessary? As Bond Girl notes, "The duration of the Fed’s portfolio is not what is standing between us and economic prosperity."

Despite the intense level of concern, U.S. swap spreads are still in what is considered to be a "normal" range, suggesting there is very little systemic risk in the U.S., and that financial markets are reasonably liquid and healthy. Eurozone swap spreads, in contrast, are quite elevated, reflecting fears that an imminent Greek default could prove contagious and ultimately bring down the European banking system and perhaps the Eurozone economy as well. Again, the risks confronting the U.S. economy today are primarily of European origin.

The very obvious problems plaguing the Eurozone have resulted in a significant decline in Eurozone equities, bringing them back down almost to their March 2009 panic lows. In contrast, U.S. equities have only been moderately affected.

As the above chart shows, the decline in long-term yields (white line) has been highly correlated to the collapse of Eurozone equities.

All of this suggests that a further flattening of the yield curve—assuming that Operation Twist is even capable of further depressing long-term yields—is unlikely to make much of a difference to the U.S. economy. The level of long-term yields, which are already historically low, is all about threats to growth; long-term yields are not an obstacle to growth, they are the result of expectations that growth will falter. Lower rates are not going to improve the outlook. Mortgage rates, now at historic lows, are not stimulating the economy, because they are symptomatic of an economy that is weak.

If the outlook for growth improves—whether as a result of Operation Twist, or the reduced risk of a European collapse—then long-term yields are almost certain to rise. Which is another way of saying that Operation Twist can't ever do what its advocates believe; any actions on the part of the Fed which end up materially improving the outlook for growth will raise long-term interest rates, not depress them. Operation Twist could only be successful if long-term interest rates rise.

I would like to believe that the Fed understands that there are limits to its ability to make a difference at this juncture. Plus, more market intervention, in the form or an Operation Twist, would only muddy the waters; a less activist Fed would reduce the level of uncertainty and risk that is plaguing markets today. If the FOMC meeting this week fails to deliver an Operation Twist, I for one would be relieved. It's not the fix for what ails the economy.


McKibbinUSA said...

Greece, Spain, Portugal, Italy, California, New York -- a monetary collapse appears imminent...

Chris McFarland said...

Thanks for your posts! Really enjoying them.

Benjamin Cole said...

The Fed needs to look firm and resolved to boosting growth.

Right now, the Fed is dithering. ala the Bank of Japan.

Fighting inflation in a recession means you will always be fighting inflation in a recession--just like Japan. Recessionary deflations are brutal on investors.

Like George Gilder said, worry about having boom-times first, then quibble about inflation rates later.

We need some of the Reaganesque bravado now.

McKibbinUSA said...

The most interesting feature of the markets today, is not how the bond markets are reacting to sovereign debt issues around the world, but rather the resilency of common stocks and rentals throughout the economic crisis -- the world may be headed for depression, and bonds may be falling apart, but high quality equities in dividend and rent-earning equities is the best defense against the corruptions of sovereign debt globally -- the other resilient feature of the global economy today is the demand for certified skills, which continues to rise unabated -- anyone following my advice regarding dividend and rent-earning equities, coupled with acquiring certified skills, is no doubt a happy camper these day...

Benjamin Cole said...

BTW, there has been a lot of harum-scarum of late about inflation. Some say the CPI overstates inflation.

Here is an interesting tidbit from Scott Sumner:

"So why is housing causing a problem for the Krugman model? The answer is simple; the BLS doesn’t agree with Case-Shiller, they don’t agree that house prices fell 31.6%. What kind of figure did the BLS come up with?

Answer: 7.7%

I can just imagine your reaction: “What!?!?!?!?! They claim housing costs only fell 7.7% over the past 5 years! That’s insane.”

I’m afraid you’d better sit down for this. The BLS doesn’t claim housing prices fell 7.7% since mid-2006, they claim they rose by 7.7%. Just a minor 39.3% discrepancy with C-S."

The CPI as constructed assumes that house prices rose 7.7 percent in the last five years.

Yeah, tell us about inflation.

This also provides a market explanation for the very low interest rates we see. Rates are low as we are in deflation, and lenders know it.

McKibbinUSA said...

Benjamin, deflation is evident all along Main Street USA...

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