Following yesterday’s meeting of the Federal Open Market
Committee (“FOMC”), the financial headlines were about “Operation
Twist,” the risky and destined-to-fail Federal Reserve strategy of
“extend[ing] the average maturity of its holdings of securities.”
But it was not just this misguided policy that cost stock investors
dearly; other aspects of the
Fed’s statement pointing to increased economic pessimism roiled
the markets, knocking the Dow Jones Industrial Average down 2.5%
and the S&P 500 down almost 3%.
Along with the cratering of stocks, the yield on the
government’s 10-year note fell to a record low of 1.86%, and the
30-year bond made a stunning fall to under 3% after the Fed said
that an unexpectedly large 29% of the securities they would buy
would be between 20 and 30 years in duration. Most of the rest will
be in Treasury notes of duration from six to ten years.
The panic accelerated Thursday morning with stock index
futures pointing to an opening 300-point loss for the Dow Jones
Industrial average, and the yield on the government
10-year note plunging to below 1.8%. Meanwhile, oil fell 5% on a
blood-red screen of commodity prices.
Let’s start with Operation Twist: Over the next 9 months, the
Fed will buy $400 billion of Treasury securities with a duration
between 6 and 30 years, and sell an equal amount of securities with
maturities of three years or less.
The move is monetarily “sterile”, meaning it does not
inject net new cash into the system and therefore is not
“QE3.” The fact that it is “sterile” means that it’s
essentially a fiscal move rather than a monetary move, and there is
a good argument to be made that this is something that, if it
really should be done — which it shouldn’t — should be done by
the Treasury instead of the Fed.
With interest rates this low, it’s a great time for the
government to be borrowing long-term, namely selling notes and
bonds of 10 to 30 years in duration. But with the Fed buying that
same paper, the government is not taking advantage of these low
rates; it’s as if the government were loaning to itself, which
gives you a clue as to just how effective this scheme is likely to
be. (To be sure, rates would not be this low if the Fed weren’t
buying long-date paper and expected to buy buying more.
Nevertheless, economic weakness this severe would have long-term
interest rates quite low without Fed manipulation.)
In addition to not taking advantage of low rates, by going
out that “far on the curve” the Fed is taking much more interest
rate risk with taxpayer money than it should ever take. (As
interest rates rise, the risk to a fixed income investment rises
with the duration of the investment.)Yes, the Fed can hold the
paper to maturity and never realize a loss. However, if interest
rates rise, which they must some day despite the bleakness of
today’s environment, the opportunity cost to taxpayers could be in
the tens of billions of dollars.
The Fed seems to think that it will spur economic activity
by lowering long-term rates because the inability to get any return
even on a 10-year treasury might spur people into buying stocks,
starting business, and might also allow more people to refinance
their homes.
But if the problem were really the competition between
long-term government paper yields and the potential return from
other investments, it’s difficult, or rather it’s impossible, to
believe that a 1.75% 10-year note (or wherever Twist might send the
yield) will somehow spur economic activity when a 2.25% rate
didn’t. No rational person will make a major change in course,
especially in an economic environment this unstable, for a half a
percent. Thus, the fundamental premise of this scheme seems
essentially preposterous.
But wait, there’s more! Many pension funds and other
retirement accounts rely on purchasing government paper for the
“fixed income” part of their portfolio. Reducing the return on
those items will harm people who are soon to retire. When
government securities offer unacceptably low yields, those funds
will find other fixed income investments, most likely the highest
quality corporate securities and perhaps some government-backed
“agency” mortgage securities. In other words, the Twist will drive
credit supply to the places that least need more credit.
Meanwhile, the part of the economy that does need more
credit, namely small and mid-sized businesses, may find the Twist
making it even more difficult to get a loan than it is now. That’s
because banks make much of their profit (or at least they have in
the past) by borrowing money in the form of bank deposits over a
short term at a relatively low interest rate and lending money,
such as for company operations, new cars, or homes, over a longer
term at a higher interest rate. By “flattening the yield curve,”
i.e. lowering the longer-term rates while raising the shorter-term
rates, the Fed creates less profit potential for banks considering
making such loans. With banks already hesitant to loan to all but
the most creditworthy clients (it’s often said lately that the only
people who can get a loan are people who don’t need one), the Twist
will further dampen banks’ interest (pun intended) in making
loans.
Certainly part of the Wednesday market sell-off was due to
the realization that Operation Twist is not an economic savior;
indeed it poses at least as much risk as potential gain for the
economy.
But one particular sentence in the Fed’s post-meeting
statement was probably even more damaging: “[T]here are
significant downside risks to the economic outlook, including
strains in global financial markets.”
Nowhere in the
Fed’s prior statement following its August meeting appeared
either the word “significant” or the word “global.” Those who
follow Fed-speak and the details of its statements are well aware
than the addition, removal, or change of a single word can have
substantial meaning.
To add the word “substantial” to an FOMC statement shows
substantial fear by the Fed that we are teetering on the
brink of another recession. Such language serves as a bearish
reminder that the Fed’s monetary gun is pretty much out of
bullets.
Additionally, the Fed is publicly fearful of the risk of
economic and financial contagion from Europe’s debt crisis — and
that’s a problem that the Fed has no real weapon to fight. Although
FOMC Chairman Ben Bernanke has made cautious statements about
European debt in the past, Wednesday’s tone was clearly different
from, for example, his August 26 speech in Jackson Hole, Wyoming,
when he said “I have confidence that our European colleagues fully
appreciate what is at stake in the difficult issues they are now
confronting and that, over time, they will take all necessary and
appropriate steps to address those issues effectively and
comprehensively.”
Thus, it’s not surprising that in addition to stock prices
and bond yields dropping, both typical of recession fears, oil
dropped more than 1.6% and copper,
often considered one of the best barometers of future economic
activity, fell 1.8% to its lowest level in a year.
The markets are screaming “double-dip recession!” and the
Fed is whispering “You may be right… and there’s not much we can do
to help.”
While the Fed should be honest in its assessment of the
economic situation — with the new sentence representing such
honesty — it should not pour fuel on the recession fire with
overtly desperate measures. As long as we have a Fed, its most
important asset is the confidence of the people and the markets.
Actions like Operation Twist, which smack of “we’re out of ideas
and out of influence,” do long-lasting damage to that
confidence.
