Today, the concern of the Fed for our economy was shown through actions dubbed Operation Twist in the popular press. Citing “significant downside risks to the economic outlook,” the Federal Reserve Open Market committee today announced they would enter the bond markets and start buying $400 billion of bonds with maturities of between six and thirty years. To provide the cash to make these purchases, the Fed also announced it would be selling $400 billion of bonds it already owned with maturities of less than three years. Hmm – selling bonds and buying them back again? What gives?
The Fed is charged with fostering maximum employment (measured by the unemployment rate) along with price stability (measured by inflation). This is also a good description of what the US Congress wants, but each of these groups comes at the problem with different tools. The Federal Reserve has at its disposal the amount and price of money in the financial system as its tools, and today it announced that it wasn’t satisfied with the price of money, specifically the price (read: interest rate) of money borrowed for longer than six years. The mechanics of how this change in longer term interest rates occurs is pretty straight-forward: the next time an investor wants to sell, say, some of his 10 year treasury notes, there will be more competition to buy that note (from the Fed), driving the price of that bond a bit higher. Since the price of a bond moves the opposite way from its yield, this higher price means the interest rate earned on that bond will be lower. And since the opposite is true, when the Fed sells its short term bonds, the flood of supply will drive prices lower, increasing the effective interest rates earned for those bonds. The movement up of short term rates while long term rates go down is that “twist” you hear about.
The theory is that by lowering the cost of borrowing for longer periods of time, companies will take advantage of this and borrow the funds necessary to invest in their expansion. Additionally, the hope is that mortgage rates will be even lower, encouraging home buyers to step up to the plate at this time. These may both turn out to be true, but we suspect the real goal of the Fed is to put an end to what is known in the arcane circles of the fixed income world as The Carry Trade. Most people assume that banks make money by borrowing from depositors and lending those funds to borrowers for longer periods of time, earning a spread between the two. While that is true generally-speaking, the Carry Trade is what occurs when a bank borrows from depositors at cheap rates and uses those funds to buy treasury notes instead of lending them to commercial borrowers. For example, at the beginning of this year, banks could borrow money from you and me at cost of somewhere between zero (think your checking account) and 0.25% (1 year CD rate). The bank could then turn around and buy 10 year treasury notes yielding 3.36% netting a risk free return of better than 3.1%. If you are a bank that is under increasing regulatory pressure and have a portfolio of questionable commercial loans, the Carry Trade starts to look better and better! By implementing Operation Twist, the Fed is seeking to take much of the fun out of the Carry Trade. If we look at the same interest rates today after the Fed announcement, one year funding may cost a bank 0.1% today, but the ability to invest it into 10 year government bonds yields them 1.85% for a net benefit of just 1.75%. That change may not seem much to you and me, but that’s actually a 43% drop in net interest income, and any bank that showed that for its quarterly report would soon show its CEO to the door.
To be sure, the regulators are still out there ready to pounce and second-guess any number of bank credit officers, but that’s an issue for Congress to tackle. The Fed has done what it can to encourage both borrowing and lending with the Twist. Let’s hope it is effective.