Ben Bernanke and his colleagues on the Federal Open Market Committee have been diligently discussing the economy and the Fed’s policy response over the past two days. This afternoon we may get to see the next act in the Fed’s unconventional monetary policy show.

In a speech earlier this month, Fed Chairman Ben Bernanke pointed out that they still have “a range of tools that could be used to provide additional monetary stimulus.” The Fed seems intent on putting these tools to work sooner than later.¹

In a previous issue (Issue 26 • July 20, 2011), we detailed some of the unconventional policy options the Fed is considering. One tool that is reportedly being considered now is a golden oldie … Operation Twist!

Whether or not we get details about this particular move after today’s meeting, it seems clear that Fed officials feel they should be doing something — anything — to boost the US economy’s slow growth and bring down a stubbornly high unemployment rate.

Twisting the Yield Curve

With Operation Twist, the Fed is digging deep into its monetary tool box to resurrect an option first used in the early 1960s.²

Back then, the Fed was attempting to influence short-term rates higher, or at least keep them stable, in part to support the value of the dollar. To do this, the Fed attempted to flatten or “twist” the normal yield curve by buying intermediate and long-term Treasury securities while selling shorter-term securities.

The first iteration of Operation Twist from 1961 to 1964 “is widely viewed today as having been a failure.” Ironically, this conclusion (and the quote) comes directly from Ben Bernanke, co-author of a 2004 Fed research paper on monetary policy alternatives. Perhaps Gentle Ben has changed his mind in recent years.³

By contrast, 40 years later, the value of the US dollar does not appear to be a major concern for the Fed. Recall that the Federal Reserve has engineered two rounds of quantitative easing already. The latest round, dubbed QE2, launched in late 2010 and ended in June 2011 with the Fed buying $600 billion of US Treasury notes and bonds over the period.⁴

The economy has yet to show much response from these efforts, with weak data in recent months once again stoking fears of a double-dip recession, just as was the case a year ago. The only tangible impact of the Fed’s quantitative easing so far, as Banyan’s Director of Fixed Income Steve Chapman points out, has been to trigger a temporary “risk-on investment climate, pushing stocks, commodities and some other asset classes higher, typically at the expense of a weaker US dollar.”

And here we are again with US growth and employment running below the Fed’s forecasts. With inflation also below target, at least according to the Fed’s analysis, Bernanke doesn’t seem satisfied to sit still.

Enter Operation Twist II … or QE 2.5 … take your pick. Here’s how it could play out.

Playing Twister with the Fed’s Portfolio

The Fed’s balance sheet is bloated with $1.7 trillion worth of Treasury securities. A disproportionate amount of these securities — $715 billion worth — have a maturity of one to five years, and another $580 billion mature in five to 10 years.⁵

The idea behind Operation Twist is to shift the Fed’s holdings from shorter-term to longer-term securities. The Fed can accomplish this in two ways.

First, by using proceeds from maturing short-term Treasury and mortgage backed securities, the Fed may decide to reinvest this money into long-dated Treasuries, such as the benchmark 10-year note.

Second, the Fed could also take a more active approach by selling some of its short-term holdings — presumably the $715 billion of Treasury debt maturing in less than five years — and then buying longer-term Treasuries.⁶

Either way, the idea is to push down interest rates at the long end of the yield curve relative to short-term rates (that’s the twist), which are already near zero anyway. The Fed hopes this move will lower interest rates on long-term home mortgage loans and business loans, which theoretically should provide some additional stimulus to the economy.

Of course theory doesn’t always work as well in reality.

Already Low Rates Not Leading to a Pickup in Lending

The average rate for a 30-year mortgage at 4.09 percent is already at the lowest on record going back to 1971.⁷

Yet, mortgage applications rose last week for only the first time in four weeks. Purchase applications jumped only 7 percent while applications to refinance existing loans were up just 6 percent last week, according to the Mortgage Bankers Association. Why the lack of response to record low rates?⁸

The problem isn’t the cost of credit for homeowners; it’s a problem of both access to and desire for credit. With an estimated 10.9 million Americans underwater on their existing home mortgages, there simply are not that many qualified borrowers. Record low rates haven’t been enough to stimulate activity in housing, so it’s unclear to us why the Fed believes even lower rates will do the trick.⁹

When it comes to spurring more business borrowing and investment, you also must consider other factors besides low interest rates.

Demand, Not Credit is Top Concern for Businesses

Many big corporations are flush with cash after paying down debt and have healthy balance sheets, as we noted in a previous issue (Issue 28 • Aug. 3, 2011). Large companies already have easy access to low interest rates through the bond market if needed.

When it comes to small and mid-size businesses across America, the ones responsible for most new job creation, access to credit isn’t the problem.

A recent survey by the National Federation of Independent Business indicates that borrowing isn’t a big issue. Only 4 percent of business owners report that getting financing is their biggest problem. The biggest concern for small businesses right now is uncertainty about sales in today’s slow growth environment.¹⁰

If the Fed manages to lower long-term interest rates by a fraction of a percent, we don’t expect it to have much of an impact on small business confidence or borrowing decisions.

What Will Ben Do?

Expectations are running high that the Federal Reserve will pull something new from its bag of tricks today, but with short-term interest rates already near zero, there’s just not much left in its monetary tool box.

Another possibility, which the Fed has hinted at, is cutting or eliminating the interest it pays to banks for holding excess reserves held with the Fed.

Most of the money created through quantitative easing thus far — $1.6 trillion in all — is sitting as idle cash reserves parked with the Fed. So the idea is that if the Fed stops paying interest on excess reserves, banks may lend more. But since the Fed only pays 0.25 percent interest now — not much of an incentive — it’s hard to imagine this move would suddenly motivate banks to make loans.¹¹

Any lasting impact on financial markets from the Fed’s next move, besides adding more volatility to the mix, is hard to predict.

After all, the purpose of QE2 was also to bring down long-term interest rates. However, while the Fed was busy buying Treasuries securities in the first half of 2011, long-term Treasury yields moved up, not down as expected.

When the Fed ended QE2 on June 30, the 10-year US Treasury note yielded 3.2 percent. Since then, rates have steadily fallen as the economic outlook deteriorated and the Eurozone debt crisis worsened. In recent weeks, 10-Year Treasury yields have dropped below 2 percent. Markets appear to be ahead of the Fed in bringing down interest rates on their own.¹²

With rates at or near record lows now, how much lower can they go, and does the Fed’s manipulation of long-term rates carry any unintended consequences that investors should be aware of?

Fed Punishing Income Investors

As we see it, one unintended consequence is to punish savers and bond investors who are finding it very difficult to earn a decent yield from their fixed income portfolios.

It hasn’t been easy navigating today’s tricky markets, and with the Federal Reserve manipulating interest rates, the task is even more difficult. Money market funds and bank CDs already pay next to nothing. When you add even a modest premium for inflation, savers are earning negative real yields today.

In our Global Fixed Income strategy we’re attempting to compensate for low US rates by selectively investing in global bond funds, including some emerging market income funds, where we’re able to earn higher current yields than are available domestically. With an average duration of just five to six years, we’re able to earn an estimated yield of just over 6 percent without taking significant risk, in our view.

In our Banyan custom fixed income portfolios, we take a security-by-security approach, favoring short- to intermediate-maturity corporate bonds. Since we’re quite comfortable owning the common stocks, we feel the credit quality of these companies offers reliable income streams averaging 6 percent and with maturities of just three years on average. 

Our view: High levels of uncertainty, not monetary policy, are holding back the economy. Lower rates by themselves aren’t likely to boost lending, spending or investment significantly.

With so much uncertainty in the air, elevated levels of volatility in markets are likely to persist awhile longer as the prevailing investor sentiment shifts from risk-on to risk-off and back again. That’s why this is an excellent time to reexamine the bond holdings in your own fixed income portfolio.

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

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¹ Board of Governors of the Federal Reserve, 9/8/11
² Wall Street Journal: Federal Reserve Considers Whether to Twist Again, 9/15/11
³ Federal Reserve Board Division of Research Statistics and Monetary Affairs, 2004
⁴ Wall Street Journal: Federal Reserve Considers Whether to Twist Again, 9/15/11
⁵ Ibid.
⁶ Ibid.
⁷ Bloomberg: Mortgage Rates Fall to Lowest on Record, Freddie Mac Says, 9/15/11
⁸ Ibid.
⁹ CoreLogic Q2 2011 negative Equity Report, 9/13/11
¹⁰ National Federation of Independent Business: Small Business Optimism Index, 9/13/11
¹¹ Wall Street Journal: Fed’s Weapons of Mass Distraction, 9/14/11
¹² Bloomberg market data, 9/8/11