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.