Operation Twist Revisited

Image: Lisa Fotios

What the Dickens is going on at the Fed?

Not a lot, and so far Jerome Powell has artfully dodged more QE over and above the $120 billion monthly purchases of treasuries and mortgage backed securities.

But he might be biding his time, waiting to see the $1.9 trillion stimulus effect on labour market slack, once vaccines do their thing.

Maybe in the background, he and his colleague are considering option 2, which I wrote about at the end of January.

That is, instead of expanding the Fed’s balance sheet further while the Treasury blasts more welfare fiscal into the economy, he might opt to reallocate the Fed’s firepower by selling some short term treasuries, and using the proceeds to buy longer term bonds to influence down long rates which have popped up of late.

Back at the time of the GFC, that artful manoeuvre was referred to as Operation Twist, and it may be on the menu again. But not just yet.

So far, the Fed has been hiding in the shadows, while market forces have been left to do their thing. The 30 year yield has increased from 1.24% last March to 1.84% in January, and more recently hit 2.3% (albeit, down 0.05 as I write) with most of the increase occurring over the last 2-3 weeks as bond rebels have been ‘normalising’ the back end.

So we’ve seen some yield action in anticipation of a full reopening and expected inflation, and while the 30 year yield is higher than other maturities, they are all positive, at least nominally.

yields all across.GIF

But the real market mover has been the 30 year curve that went positive on a real basis.

That is, the nominal or published bond yield minus inflation went positive and that’s what’s momentarily knocked gold from its perch - see the brown line below. That is when real interest rates go up, it becomes expensive to hold a non-yielding asset like gold.

breakeven 2.15.GIF

But yields are not getting too far away just yet.

Let’s not get too carried away (like equities markets did for most of last week). The 30 year real yield is moderately positive. And gold is perking up a little.

The equities market might be calling for more Fed buying to prop up equities (particularly high PE growth stocks) but the Fed is unmoved and will probably wait to see how fiscal welfare and stimulus effects the economy, and whether enough labour market slack gets hoovered up as vaccines do their job.

It’s a reactionary actor at this point and probably also sees a further $2 trillion in the Biden/Yellen ‘new deal’ on the horizon as well.

Yup, there’s still a lot to play out until we get there, and there’s no guarantee that yields will run away, but we might see the Fed revisit Operation Twist over the coming months if long yields run too far in Powell’s opinion, and the Fed is forced to act again.

So, lower for longer, but perhaps with a twist - so don’t get conned by the dodger!

Mike.

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