In Preparation Of The Fed’s Last Doubling Down: David Rosenberg Believes QE3 Will Be Nothing Short Of “Operation Twist 2”
It is no secret that to a deflationist like David Rosenberg bond yields have to go lower… Much lower. With the 10 Year flirting with a 2 handle one would think he would be content. Alas no. In fact, as he suggests in his piece from today, Rosie is convinced that the next iteration of QE will be nothing short of a redux of the 1961 initiative to kill the then gold exodus known as “Operation Twist” (recently dissected by the San Fran Fed). Incidentally it was the same Fed that compared QE2 to Operation Twist. It is only logical that Rosie would then suggest that QE3 would be nothing short of a complete clearing of the 10 Year bond in the market via the Fed in order to anchor expectations that the 10 Year rate would never go up (or reasonably “never”) in the biggest gamble of all: that the Fed will attempt to both control its balance sheet and target Long-Term interest rates, a mission doomed to fail…But not like that will prevent the Fed from setting off on such a mission, especially following today’s official confirmation of the Housing Double Dip (someone page Jim Cramer). As Rosie says: “Now it is doubtful that the Fed would ever target the long bond. In fact, the Fed may even want it to be higher in yield to ease the pressure on radically underfunded pension funds. While the Fed can either target its balance sheet, which it has been doing with these QE measures, or target interest rates, it cannot do both at the same time. So the next ‘QE’ will not be called ‘QE’ but rather something else — maybe Operation Twist 2 (OT2 — you heard it here first). The Fed would buy up all the 10-year notes needed to clear the market at the target “price” (yield). So depending on supply conditions and demand from the private sector, the Fed would basically lose control of its balance sheet, but if in return this policy is the one that blazes the trail for a turnaround in the housing sector and a durable revival in the economy, so be it.” And keeping in mind that the true unspoken reason for Operation Twist 1 was to terminate the outflow of gold from the US to foreign bank vaults, we find ourselves agreeing with Rosie that an insane idea such as OT2 is precisely what the Fed would do to avoid a recurrence of the 1961 gold exodus (and attempt to give housing one last failed boost). As many birds would be killed with one stone, the only downside, that of a complete balance sheet implosion following OT2, certainly seems quite acceptable to a central bank now officially run by sociopaths.
From Breakfast with Rosie:
Since just about everything that has to do with the economy is either directly or indirectly priced off the 10-year part of the curve, it stands to reason that this is the segment that matters most for the economy. The 10-year part of the curve is the oxygen tank for the market and macro backdrop, yet the Fed in its latest QE round centered its efforts more on the front- and mid- part of the curve.
There is little doubt that the housing market is suffering from a variety of obstacles, but what is clear from the consumer survey data is that households do not believe that interest rates will come down any further. The Fed can only do so much to deal with a de facto vacancy rate of 10% for the homeownership sector (double the norm) but every little bit helps at the margin and certainly it can do a much better job at influencing affordability levels to stimulate some demand growth.
People need to be convinced that once they make the decision to finance a purchase that they won’t run into a period of rising rates that could impede their debt-servicing capabilities. This is where the Fed can play a role in influencing expectations and it is critical (this is particularly true for borrowers who are up for variable-terms mortgages).
Look, we know that: (i) Bernanke is a disciple of Milton Friedman, and (ii) one of Friedman’s classic pieces of economic research pertained to the ‘permanent income hypothesis’, which postulated that it is changes that are deemed to be permanent, not temporary, that induce a permanent change in economic behavior. This is why the “permanent” Bush income tax cuts in 2000 worked so much better than the temporary rebates unveiled in early 2008.
Therefore, at the margin, in order to do even more to solve the ongoing depression in the housing market, which continues to pose as a dead-weight drag on the entire economy, it may well behoove the Fed in its next round of stimulus, whenever that may occur (but it will, just not at 1,330 on the S&P 500), to signal to the public its intent to take down and hold down the most critical interest rate of all for the mortgage market — and that is the 10-year note.
Don’t think for a minute that this not being discussed — Bernanke talked about embarking on such a scheme, if necessary, when he was still governor back in 2002:
Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time — if it were credible — would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt … Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities … Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond- price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951. Prior to that agreement, which freed the Fed from its responsibility to fix yields on government debt, the Fed maintained a ceiling of 2-1/2 percent on long-term Treasury bonds for nearly a decade.
Ben Bernanke, Deflation: Making Sure “It” Doesn’t Happen Here, speech to the National Economists Club, Washington, D.C., November 21, 2002.
This was otherwise known as ‘operation twist’. There is certainly nothing preventing the Fed from targeting the 10-year Treasury-note any more than the Fed funds rate. But the funds rate is already near zero and as such there is no incremental move there that can benefit the economy. But targeting the 10-year note in much the same fashion is probably worth a try and if there is anything else we know about Ben Bernanke. It is that…
(i) he will be late, not early. So, by the time this comes the economy may well be back in recession, which in balance sheet cycles tend to occur every three years, so mark 2012 down in your calendar;
(ii) he is willing to be very aggressive when the time comes — he has certainly proven that. Back in 2007 or 2008 for that matter, who believed that short rates were going to vanish entirely and that the Fed would be buying assets by early 2009?
Now it is doubtful that the Fed would ever target the long bond. In fact, the Fed may even want it to be higher in yield to ease the pressure on radically underfunded pension funds. While the Fed can either target its balance sheet, which it has been doing with these QE measures, or target interest rates, it cannot do both at the same time. So the next ‘QE’ will not be called ‘QE’ but rather something else — maybe Operation Twist 2 (072 — you heard it here first).
The Fed would buy up all the 10-year notes needed to clear the market at the target “price” (yield). So depending on supply conditions and demand from the private sector, the Fed would basically lose control of its balance sheet, but if in return this policy is the one that blazes the trail for a turnaround in the housing sector and a durable revival in the economy, so be it.
If the Fed were to be concerned about the impact that any further balance sheet expansion could have on the U.S. dollar, it could always nudge the short end of the Treasury curve up in support of the greenback (short-term spreads matter more in the FX market). By doing this, the Fed would also lend some much-needed support to the troubled money market fund industry (for more on this front, have a look at Low Rates Put Pressure on U.S. Money Markets Funds on page 13 of today’s FT). So much can be accomplished with such a policy—the upside potential will be worth it.
However, politically, the Fed has to wait for the next downturn in economic activity and reversal in the stock market so that those on Capitol Hill that are lamenting the Fed’s interventionist efforts end up begging for more. This could come sooner than you think, but likely not until we see the whites of the economy’s eyes — and early signs are showing a visible sputtering in growth.
One last item to note. If, say, the 10-year note were to be capped at 2 1/2%, where it was at ahead of the QE2 program last fall, compared with the current 3%-plus level, the total return for a 10-year strip would come to over 10% in a 12-month span. Now put that in your pipe and smoke it!5 views