Wednesday, September 21, 2011

Operation Twist: Complete Analysis

Back in August, in Gold Corrects: What Next?, I wrote that I felt another round of Quantitative Easing (QE) from the Federal Reserve was on hold and the next form of stimulus would come from our federal government in the form of a job stimulus act.

A few weeks ago, the job stimulus act was announced and I discussed the details in The Jobs Act.

In August, I wrote that the next move for the Federal Reserve would be a program called Operation Twist.  I promised I would discuss the program if it were announced and today we got word that it is on the way from chairman Bernanke.

The program was used during the 1960's as a strategy to lower the interest on longer term bonds.  To explain the program in simple terms, imagine that the Federal Reserve has $1 trillion in bonds on their balance sheet.  Let's say this is how they are spread out:

$100 billion - 1 year bonds
$400 billion - 2 year bonds
$400 billion - 5 year bonds
$100 billion - 10 year bonds
$1 trillion total balance sheet

Bonds that have a lower "term" (number of years) on them are considered safer.  Why?  Let me give a quick example with how government bonds work:

Two men, Larry and Michael, decide to take $100,000 they have saved and purchase government bonds.

Larry decides to be "safe" and purchase $100,000 in 2-year government bonds.  The interest rate on these bonds (real prices as of today's market close) is .15%.

That means Larry will collect $150 per year in interest ($300 over two years) and at the end of the two years the government gives him his $100,000 back in full.

Michael thinks only a fool would accept such a low payout.  He purchases $100,000 in 30-year government bonds.  The interest rate on these bonds (real price as of today's market close) is 2.99%. 

That means Michael will collect $2,990 per year in interest ($5,980 over two years), but at the end of the two years he still has 28 years remaining on his bonds.

Michael doesn't care. He has dinner with Larry and mocks him for only earning $150 per year while he has raked in over $6,000.

Then something changes.  The endless trillions of dollars that the Federal Reserve has printed begin to enter the economy and the value of the dollar against other currencies begins to fall.  Imports become more expensive and inflation begins to rise.

In order to combat inflation, investors are now asking for a higher interest rate.  If annual inflation rates are now at 5% per year, new investors begin asking for 6% interest per year in order to cover the cost of inflation and get a real return on their money.

Michael is now nervous.  He decides he wants to sell his bonds and get his money back.  After all, his financial advisor told him that bonds are safe and they have never gone down for as long as he has been in the business. (They have been rising for 30 years)

When Michael calls his advisor he finds out that with interest rates now at 6% instead of 3%, his bonds are now worth $50,000 instead of $100,000.  His retirement money is now cut in half and interest rates are continuing to rise every month with inflation.

Larry puts his $100,300 (after adding his interest) back into the bond market and is now getting a 6% return per year on his $100,000.  Dinner parties are now very different, Larry usually picks up the tab.

Back to the Federal Reserve and Operation Twist...
(This is a hypothetical balance sheet to make it easy to understand)

$100 billion - 1 year bonds

$400 billion - 2 year bonds
$400 billion - 5 year bonds
$100 billion - 10 year bonds
$1 trillion total balance sheet

The Fed has announced that over the next 9 months they will be selling $400 billion in bonds with 3 years or less, and buying $400 billion in bonds at 6 and higher years (bonds go up to 30 years).

This is not an increase in the money supply.  It is only meant to "twist" their balance sheet and lower the interest rate on longer dated bonds.

9 months from now the hypothetical balance sheet will now look like this:

$50 billion - 1 year bonds

$50 billion - 2 year bonds
$400 billion - 5 year bonds
$300 billion - 10 year bonds
$200 billion - 30 year bonds
$1 trillion total balance sheet


Why would they do this?

It lowers the cost of borrowing for businesses and consumers who usually have their rates set against either the 10 or 30 year government bond.  Mortgage rates fall into this category and it is another tool the Fed is using to drive down rates.

The surprise today was that the Federal Reserve decided to buy 30 year bonds.  Many did not think they would move that far out on the risk curve.  They have decided to buy $120 billion in 30 year bonds, which coincidentally, is the exact number of new 30 year bonds the government will be selling over the next 9 months.

In other words: the Fed is buying all the new issuance.

While this may not stimulate the market or economy with new money, in addition to lowering rates it has provided the Federal Government a blank check to go out and spend.  Bernanke has handed the check book to Obama and if you have turned on your television the last 2 weeks you know that Obama is ready to begin writing checks.

What are the dangers?

The first is danger is for the Fed itself.  If interest rates rise, the assets they are purchasing would be "underwater" in value (example above).  This does not mean the Fed would go bankrupt because they always have the ability to hold the bonds until they mature.

However, in normal times when inflation is rising, the Fed lowers the money supply by selling bonds back to banks and taking away their cash.  This takes money out of the system.

If their assets are underwater they will not be able to sell them without taking the writedowns.  They will be trapped and helpless to stop the inflation.  This is extremely important to understand when forecasting what is ahead.

Second, is that banks make money by borrowing short term bonds and lending at long term rates.  For example, they will go into the open market and borrow $300,000 in 2 year bonds.  They then lend this money to a happy new home owner in the form of a mortgage for 4%.  They keep the spread.

If the Fed lowers the longer term rates, the banks profits will fall at a time they desperately need them.

What is the effect on the markets moving forward?

I believe the markets are headed for trouble based on how quickly the banking system is collapsing in Europe, a topic I have discussed in detail the past few weeks.

A sharp fall in the markets will open the door for the next round of Quantitative Easing, which I believe is right around the corner.

Prepare for a combination of both fiscal and monetary stimulus heading into the next election, as they will do everything in their power to juice the markets and economy one more time before the real collapse arrives.

Keep plenty of dry powder (cash) available to purchase assets on sale, but continue to hold your strong core positions currently in place.

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