Is Operation Twist a Failure? The Fed’s Two Left Feet.

“Oooh-yeah just like this
Come on little miss and do the twist” – Chubby Checker, The Twist

I thought the quote was pretty clever, but you could also attach one of a couple of subtitles on this post: “Why Thomas Sargent Deserves Half the Nobel Prize” or, if you like classic entertainment, “A Funny Thing Happened on the Way to the Dance”!  Let’s stick with Thomas Sargent, who just won the Nobel Prize in Economics for his work in the field of “Rational Expectations”.  “Rational Expectations” in Economics, as you might guess, refers to the changing expectations of the market (investors, citizens, whomever) to policies that will affect them.  Basically, you cannot assume that the reaction to a new policy will have the desired effect.

“Don’t Fight the Fed!”

As the Wall Street Journal article linked above makes clear, this affects both permanent and temporary policies.  Temporary policies have the problem of not affecting long term decisions (a temporary tax break may lead to temporary hiring, for example, but not permanent positions).  Permanent policies have the problem of market participants assuming that something will happen, and increasing their current expectations to meet the expected future scenario (the WSJ uses the example of loose monetary policy not helping unemployment since people assume inflation is on the way and adjust their demands accordingly).

How does this fit into the Fed’s so called Twist program?  The declared intent of the program is for the Fed to use short term debt to buy long term bonds and to ‘flatten the yield curve’ (which means to bring the return on long term debt closer in line to short term debt).  The problem with the Twist is that the Fed told us about it!  There is a phrase in finance – “Don’t Fight the Fed.”  The Fed is a whale – a huge, slow, lumbering purchaser.  As long as market participants (minnows, sharks, and all sorts of other fish and mammals) swim in the same direction, they avoid the turbulence caused by the whale, and don’t lose money.  Even better, the other fish are faster *and* quicker than the whale.  So, while the Fed is announcing it is about to finance the purchase of massive amounts of debt with short term debt, it is a signal that all other market participants should go buy long term debt since the Fed is about to drive their prices higher (prices and yields move in the opposite direction).  So, it’s likely that’s what you’re seeing right now in the Treasury market.  The very fact that the Fed declared their policy beforehand is causing the policy to have the opposite of the desired effect.  The yield dropped immediately as investors bid up the price, but as investors start to suspect that Twist purchasing is slowing down, they won’t pile into the trade, as it’s too late to front run the Fed (don’t buy after the whale!).

And the Graph!

News broke on the 15th of September of Operation Twist, so I’ve scientifically chosen to graph September 12th through the 11th of October, so you can see the success after the announcement followed by the downward pressure (yield increase) from investors selling the news.  Most of the debt being sold matures in 2013, so I’ve included the 2 year yield as well. Data from the US Treasury.

(if you are reading this in a feed, open the article to access dynamic data)

Conclusion

A lot of people not fighting the fed means mini yield rallies before investors expect the Fed to buy and when the Fed buys (you can see one rally started September 22nd when Twist was official and another on October 3rd when the Fed was buying). If you can get in before the Fed, great, but don’t get stuck in its wake. Also, great pick on the Nobel.