The Downside of Operation Twist
The Federal Open Markets Committee (FOMC) chaired by Ben Bernanke announced today they intend to extend “Operation Twist” through the rest of this year.
The major equity markets weren’t exactly thrilled with that, but they didn’t throw up either. The DOW closed down about 13 points in what market watchers like to call “mixed trading”.
That means stock traders don’t know what to think about The Fed’s action.
They had hoped for “QE3” where they could make a ton of money trading off the federal government buying up a bunch of assets nobody wants at inflated prices. Maybe next time.
Sooo… what is this “Operation Twist” thingy?
According to Newton’s third law of motion… for every action, there is an equal and opposite reaction.
It sounds kinda silly, but lets apply that law to “Operation Twist”.
Operation Twist has a boring banker name – “Maturity Extension Program“. It is just one of the many weapons The Fed has in its mighty arsenal of non-standard tools to meet its dual mandate of maximum employment and price stability set by Congress.
In point of fact, its just the The Fed selling holdings of short term treasuries it already owns and using the cash to buy longer term treasury securities.
The idea of that is to drive down the interest rates on long-term treasury securities, like 30-year ones.
That makes 30-year home loan mortgages cheaper. Then us ordinary little guys can afford to rush out and buy homes. When we do, it drives up demand for houses that drives up home values which builds wealth and then everyone lives happily ever after.
It has a similar effect on long-term business investments.
Operation Twist is intended to help promote the “full employment” mandate we all hope for!
According to The Wall Street Journal, The Fed plans to buy about $237 billion in long-term securities.
The Equal and Opposite Reaction
Sooo… where do all these short-term treasuries that The Fed owns come from?
Welll… they come from buying up federal government debt. That’s where! The Fed buys around 70% of all U.S. sovereign debt. That, of course, adds to the national debt.
This year – 2012 – for perhaps the first time in at least 40 years, fully 100% of all growth of the U.S. national debt will be sovereign debt. Not a good thing.
Contrary to popular belief, most sovereign debt will not be bought up by the Chinese. It will be bought up by The Fed! The Fed’s share will be somewhere around $500 billion more from now through the rest of this year.
Since at least the mid-1970s sovereign debt growth was held down by borrowing against the Social Security and Medicare Trust Funds. As of about 2 years ago, neither one can support itself anymore so you can kiss that national debt funding source goodbye.
If you sell short-term 2-year treasury securities bought at today’s .32% interest rate and use them to buy 30-year securities at today’s 2.72% rate then you just increased government’s cost of borrowed money by 850%!!
That, of course, makes the interest cost of servicing the national debt higher. The higher it is, the less money is left over to pay for actual government services.
That is the downside of “Operation Twist”.
Here is the really bad news…
The Fed has already been applying “Operation Twist” since last September. Perhaps many of you failed to notice, but there hasn’t been an upsurge in home sales or prices or business investments. Home values remain at very depressed levels. Op Twist hasn’t worked yet!
Some would argue there just hasn’t been enough time for it to have a measurable effect. Last month’s economic indicators certainly confirms that hypothesis! 😉
Perhaps 6 more months and $237 billion more in 2.72% 30-year treasuries of national debt will have a positive effect. Perhaps it won’t.
When the economy eventually recovers then paying 2.72% on 30-year treasuries will still be a bargain. It will help slow national debt growth over the long-term.
That being said, in the short-term national debt interest costs will be much, much higher and that could more than offset its long-term benefit should the U.S. economy be slow to recover as predicted.