Operation Twist
By Stephen Smith
2011-10-24
On September 21, 2011, the Federal Open Market Committee (FOMC) directed the Open Market Desk at the Federal Reserve Bank of New York to purchase, by the end of June 2012, $400 billion in par value of Treasury Securities with remaining maturities of 6 years to 30 years and to sell, over the same time period, an equal par value of Treasury Securities with remaining maturities of three years or less. The size of the operation is probably best put into context by comparing it to Quantitative Easing 2 (QE2). The two operations are not directly comparable because QE2 involved only purchases spread out across the yield curve, while the new initiative involves sales of short-term securities and purchases of long-term securities. To assess one against the other we need a common denominator. QE2 required $600 billion of purchases and the new initiative is about $685 billion. See the table below.
The FOMC will also reinvest principal payments from its holdings of Agency debt and Agency Mortgage-Backed Securities in Agency Mortgage-Backed Securities. The estimated amount is about $20 billion per month. The return to the mortgage market could be significant because it could lower mortgage rates by reducing the spread of Mortgage-Backed Securities to Treasuries. The FOMC's announcement led to a huge rally in the 10 year and 30 year Treasuries. The 10 year Treasury is currently yielding 2% and the 30 year Treasury is currently yielding 3%. Lower mortgage rates are important because they could produce more refinancing. Those who will be able to refinance will enjoy an additional income stream from the lower mortgage payment, therefore, it's equivalent to fiscal stimulus for the economy.
Even after these decisions, the FOMC maintains an easing bias, and the Committee is prepared to do more should the economy not improve. The mechanics of the new initiative and QE2 are fairly similar where both are reducing long-term rates and both could provide incentives for investors to move out on the risk spectrum. The current earnings yield on the S&P 500 is 7.5% compared to a 2% yield on a 10 year Treasury and a 3% yield on a 30 year Treasury.
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