Why More From Operation [Oliver] Twist May Not Be Enough


The problem is, ‘more’ has been given, and yet ‘more’ still, and it has not proved to be enough, for markets or the real economy.

What you will not find this afternoon, is an economist or anyone attentive and informed in the market who does not expect an additional accommodation by the Federal Reserve at it’s post meeting announcement, coming at 1815 GMT/1415 EST.

That’s the majority view.

Not cast in stone, of course.
There appears to be still sufficient leeway, even after the soundings by Federal Open Market Committee members over the last several weeks, for a materially downgraded version of the widely held expectations to be realized.
Those widely held expectation for the sake of completeness, and briefly put:
Fed will extend the duration of its Treasury portfolio, buying longer-dated notes in exchange for front-end paper. This would be an “active twist” policy where the Fed sells front-end paper outright to fund long-end purchases rather than simply relying on proceeds from maturities.
A little drill-down:
A higher proportion of buying is most likely in the 25-30-year segment targeting benefit to mortgage holders.
That would flatten the fronts-30s curve and widen the back-end swap spreads, flattening the curve overall and a steeper swap spread curve.
So, if the above doesn’t transpire, naturally, disappointment will translate into some sort of ramp in yields – although given the wider environment, that outcome is more than ordinarily sensitive to the global picture. 
 As for how much the Fed might ‘twist’: estimates I’ve seen range between USD250 billion-to-USD600 billion but consensus seems to be nestling within USD400B-500B.
Again, the latter obviously has implications for the immediate and short-term dollar reaction to any material overshoot or undershoot of what looks like the main expectation.
It’s also worth bearing in mind that since 30-year yields have tanked that much more than 10yr recently, some very long-end buying might be a logical move.
The foregoing aside, as you know, the Main Game is not ‘if’ ‘twist’ will happen [with necessary provisos that it still might materially not match expecations] but rather ‘how’ to finesse the extremeties of probabilities and tail risk.
 So, let’s look at the former first.

 What if the Fed was more, not less aggressive than wide expectations?

The Fed could indeed make an announcement of new outright securities purchases, with a corresponding likely unequivocal boost on the dollar.

[QE3 – of course]:

It would have to be at least $600B – the same as QE2, and probably more – perhaps as much as $1tr.
But at this point, more outright QE would be an outright shock to most Fed watchers, I think.

There are likelier, non-twist tools in the kit.
A brief round-up of the least exotic:
Price level targeting – requires running an inflation rate above a “target rate” to boost nominal GDP.

But it can only realistically be achieved by outright QE, so presents the same issues as option one. It also brings in already ‘above target’ inflation.
Bond yield targeting – like twist, but adding a target for points along the yield curve – say 10Y yields at 1.5%, 30Y yields at 2.8%.

But analysts who do speculate about that last one also wonder about its efficacy.

OK, how about, the Fed could cut the interest rate it pays on reserves (“IOR”) from 25bp, to perhaps 12.5bp.

This might encourage funds held on the Fed’s current account to shift to lower-risk assets; but again – efficacy is difficult to predict.

At this point, I’m fairly sure that most of you would rather not read much more than that about this FOMC meeting [if you even made it to this part without clicking away.]

To me it makes sense to conclude that the biggest risk – and I don’t think it’s naive to say even this afternoon – ironically, is still disappointment.

Whilst the Fed could purchase almost $800B in the 5-15y sector in a twist, before hitting its own 70% limit; this is not 2010.
The US political atmosphere is different today, than it was then.

Today’s one includes, amongst other aspects, a sharper, more confrontational political focus on the Fed and even Bernanke himself which ought to be taken into consideration.

Further, lower US long-term yields could help neutralise some of the sting of the financial crisis, true.

And with a fall in mortgage costs, a reduction in recessionary consumer deleveraging and cash-hoarding would also be welcome.

If it happens.

But with borrowing costs already at record lows and negative equity, how much of a further advantage could yield shrinkage offer the consumer?

As for the markets, the risk of re-directed funds finding their way back into Treasurys, especially in the current environment, is clear enough.

Emerging market assets as yield plays are also potentially more tempting than the real economy.

So we could instead of stimulus be left with even more compressed yields and little in the way of growth.

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