Operation Twist Is Totally Skewed

This post should have been about gold, but instead it's another macro impact study of US government initiatives in the interest rate market - this is in part because the gold story has to remain in draft format until some "opinions" have been delivered, and in part because global concerns are yet again focusing attention on the US long term Treasuries.  These concerns include a Chinese property implosion and general economic slow down, oil "inflation", and Euro zone credit issues (inquiring minds and anyone prone to worrying about economic facts, might even want to know who is going to make good on the Greek CDS).


Without further ado:


Anyone remember the purpose of Operation Twist? Good - you may want to skip the rehash and start with the next paragraph. Now, for those who failed to obsess over yet another attempt by Bernanke to resurrect the US housing market, here's a brief synopsis: late September last year the US Federal Reserve initiated a program to buy longer dated paper in an attempt to drive down long term rates; specifically, $400 billion held in short term paper (less than 3 years to maturity) was to be reallocated to longer term Treasuries. The program is set to finish this June. Lower yields in longer dated paper, as a result of increased demand by the Fed, should, the theory goes, "twist" the yield curve in favor of long term borrowers - AKA mortgage borrowers. 


Back to reality. First, without trawling through a huge amount of data, how does a $400 billion "spend" on longer dated Treasuries stack up? Spread over up to ten months, in an uncertain global economic environment where liquidity in the multi trillion dollar Treasuries' market remains without compare, a spend of this magnitude is still important. Beyond its purchasing power, and of greater importance in the near term, there is the obvious headline power of a Fed program, and the "promise" that on-any-given-day contrarians can be "punished". 


Trying to establish the medium term expectations that the Fed had for Operation Twist remains a challenge, but the Reserve Bank of SF published a working paper in February that tempts the reader to accept that a relatively minor effect of 15 basis points on the 10 year equates to "success". Extrapolating from Fed working papers (especially one that's not specifically dealing with assessing the effects of the current Operation Twist, but focused on comparing JFK's 1960s Nudge/Twist to Bernanke's QE1) is problematic, but at least we're dealing with Fed thinking/analysis and rationalizations. This time the "nugget" is that the Fed aren't likely to measure their success in the same way as the markets, or, for that matter, your average house owner. The Fed is likely to declare a 15bps impact over almost a year on the "10 year" as a "victory" - the rest of us probably won't be quite as excited, and now, with the return of higher long term yields, the program's headline power seems to be fading.


So, is this the end game? The US interest rate environment remains a very intriguing study. Conditions for a recovery in the housing market appear to be present - apart from the fact that the securitization markets (CMOs) are still in the process of being unwound and MREITs are decreasing leverage. As to banks... well, their traditional role (since the early 90s) has been to originate and bundle loans - a business that's still mired in law suits, and, perhaps inadvertently, hamstrung by the decreased spread c/o Operation Twist. This really is the point in time, a few months before the proposed end of the Twist, when it's become abundantly clear that the current skewed interest rate curve will, barring a global calamity, continue to steepen. 


Take an interest rate curve reverting to "normal"; a deleveraging financial system; and a US Treasury keen to "profit" from low long term yields (playing along with Operation Twist will have restrained their ability to act - maybe now they'll even consider perps and 50s, like the UK), and it all adds up to... more of the same. That is, the economy has to do what is fundamentally important, which is to continue to write off and deleverage. Operation Twist gave us a temporary skew, some time to act, but it wasn't a victory (no matter what the Fed says).


In terms of positioning, as the yield curve becomes steeper and spreads widen, maintaining a positive cash flow short bias on the long bond continues to make sense. As long term yields continue to climb it becomes imperative to be paid to maintain this short to offset interest expenses. Targeting the increasing spread also allows for some interesting trades in the agency paper sector.  Global concerns may affect these strategies in the short run, but the fundamentals now dictate a wider spread and higher long term yields.