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QE3 or Operation Twist 2 Coming?



August 04, 2011 – Comments (0)

[Note: The Post of the Day will be on hiatus tomorrow, returning Monday August 8.]

Board: Macro Economics

Author: notehound

I am sure that the Fed is aware we are entering what looks like another deflationary leg down in the economy. Given this turn of events, a post on ZeroHedge from a couple of months ago (citing Bill Gross and others) appears to be pretty much on target as to what Messrs. Bernanke et cie are likely to do in the next few months: take further action to "assure" frightened borrowers-to-be that interest rates will stay down for a long time - thus "theoretically" spurring borrowing and helping the moribund residential real estate market.

Below I have posted an excerpt that seems to suggest that the Fed may decide buy up all the 10-year Treasury Bonds and thus not merely manipulate, but fully control, interest rates. In other words, neither China nor any other ordinary Treasury purchaser could demand a higher yield because the Fed would simply buy up all the 10-Year debt offered with digitally-created dollars. They could do the same with the 2-year or any other maturity they pleased. Something similar in the 1960's was called "Operation Twist" - and was used to discourage the expatriation of gold.

Since just about everything that has to do with the economy is either directly or indirectly priced off the 10-year part of the curve, it stands to reason that this is the segment that matters most for the economy. The 10-year part of the curve is the oxygen tank for the market and macro backdrop, yet the Fed in its latest QE round centered its efforts more on the front- and mid- part of the curve.

Don't think for a minute that this not being discussed — Bernanke talked about embarking on such a scheme, if necessary, when he was still governor back in 2002:


"Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time — if it were credible — would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt ... Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities ...

Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond- price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951.

Prior to that agreement, which freed the Fed from its responsibility to fix yields on government debt, the Fed maintained a ceiling of 2-1/2 percent on long-term Treasury bonds for nearly a decade."

It looks like once again, the manipulators will ensure that risk is mispriced in a vain attempt to "fool" the frightened consumer into borrowing, consuming, building, etc.

What they don't realize is that the problem is not that the would-be borrowers fear rising interest rates, they fear the loss of a job. Someone who is working and confident that they will remain working is not afraid they will be unable to make a payment. It's the person who fears losing a job, on the other hand, won't venture to obligate himself even if the interest rate is 0%.

Likwise, an employer that is confident it will be able to maintain its sales levels and cashflows because it knows its future obligations are somewhat predictable may be willing to expand and hire additional employees. On the other hand, if that employer fears unanticipated loss in sales - or hikes in taxes, costs, overhead or red tape, he will not be motivated to hire or borrow. Even if interest rates are still absurdly low.

Pushing on a string is insanity. Merely changing the form of QE will not make it effective nor will it create jobs - as jobs are the only real cure for our ills.

I simply shake my head and say "will there never again be normally-operating markets - for debt or for anything else?"


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