Why The Fed Might Bring Back ‘Operation Twist’ (VS Yield Curve Control) In 2021. Will 1% Yield Force The Fed Into Curve Control?
As the 10-year Treasury yield climbs, Wall Street’s 2021 outlooks provide clues for just how much of a selloff the central bank will tolerate. Will 1% Yield Force The Fed Into Curve Control?
Examples of YCC Programs : During World War II, massive borrowing by the U.S. federal government was necessary to fund the war effort. However, this threatened to send interest rates soaring, making such debt increasingly more burdensome to service. In response, from 1942 to roughly 1947, the Fed successfully kept the government’s borrowing costs down by purchasing any government bond that yielded more than certain targeted rates. Notably, the government was able to reach its goals with relatively modest bond purchases. 
There’s nothing that whips Wall Street into a frenzy quite like a sharp move higher in U.S. Treasury yields.
For instance, consider this Bloomberg News headline from last Wednesday, when the benchmark 10-year yield touched 0.96%: “Treasury Yield Spike Risks Sparking Domino Effect in Markets.”
Investors saw the possibility that stocks would be “vulnerable to a reasonably significant correction,” that the price of gold could stumble and that the dollar might weaken from an already two-and-a-half year low.
All this, even though current long-term U.S. yield levels would have been unprecedented just 10 months ago and barely register as a blip on a chart of recent history.
So far, there’s little sign of a ripple effect like the ones in previous years. On Friday, the 10-year yield jumped to as high as 0.9842%, closer to 1% than any time since March, after a middling November jobs report. Stocks nevertheless advanced to record highs.
The sanguine reaction is in no small part because traders expect the Federal Reserve to quickly clamp down on any large and sustained increase in long-dated Treasury yields, which influence everything from mortgages to auto loans to borrowing costs for heavily indebted corporations.
Some strategists suggest the central bank will announce such a move to tame the bond market on Dec. 16 by extending the weighted average maturity of the $80 billion in Treasuries it purchases each month. That’s not quite yield-curve control in its purest form, but it effectively sends the same message: We won’t tolerate a selloff of this magnitude.
Is a 10-year Treasury yield of about 1% enough to spook the Fed into action? The answer may depend on which bank’s forecast for 2021 you trust.
I wrote last month about Goldman Sachs Group Inc.’s prediction for next year, which is for a modest increase in 10-year yields to 1.3%. JPMorgan Chase & Co. expects the same. Barclays Plc forecasts the 10-year yield to rise to just 1.25% by the end of 2021, while BMO Capital Markets expects it to hit that mark “at some point” next year, but investors will view it as “an enticing opportunity” to buy.
Morgan Stanley sees 1.45% at the end of 2021. Bank of America Corp. says 1.5% for the 10-year note, while the long bond will reach 2.4%, leaving the curve from five to 30 years at the steepest since early 2014.
This would seem to suggest that Treasury yields still have room to run before the Fed would intervene, particularly given that interest rates are increasing because of the prospect of fiscal aid in the short term and a potentially supercharged economy next year.
Most bank strategists are forecasting a slow and gradual build to those end-of-2021 levels. In that sense, the world’s biggest bond market is right on track without the central bank doing anything differently.
Meanwhile, the median forecast among 53 analysts surveyed by Bloomberg is for the 10-year yield to end 2021 at 1.15%. TD Securities is among those who expect yields will be lower a year from now, calling for 0.9% for the 10-year note and 1.65% for the 30-year bond.
“If monetary policy is now shifting to a role more akin to [yield-curve control], this limits the rise in yields but is not looking to depress them further,” TD strategists wrote in a Dec. 2 report.
The bank’s strategists expect the Fed to announce it’s extending the maturity of its bond purchases in December to achieve this balance:
Central banks have tried to support growth and inflation by taking duration, and thus term premium, out of the market.
The evidence overwhelmingly suggests that QE compresses term premium, precisely one of the mechanisms targeted by central banks to influence the economy.
In this context, the long road to recovery from the COVID-induced economic carnage will likely keep asset purchases a key feature of stimulus efforts, especially in the coming months.
But … there is an inherent drift in the current policy to see QE purchase less of the net issuance — especially in the US. Our expectation is that the Fed will extend the weighted-average-maturity of Treasury purchases, which would help to prevent a large rise in the term premium, though not push it lower, as other factors work through.
Still, in a BMO survey asking whether the Fed will extend its weighted-average maturity in December, 56% of respondents said no, while 44% anticipate the change will be formalized.
This is a rather unusual rift for a policy move that could have lasting implications for the level of long-term yields and the shape of the curve.
In congressional testimony last week, Fed Chair Jerome Powell noted that the central bank was in no hurry to taper its bond buying but also gave no signal that it was ready to necessarily do more, either.
He and other officials have made the point that purchasing $120 billion a month of Treasuries and mortgage-backed securities is already a huge sum based on precedent.
They won’t have much of a chance to provide more clarity — policy makers are now in their self-imposed quiet period before their decision next week.
One potential wild card: Quantitative strategists at Nomura Holdings warned last week that systematic players known as commodity trading advisors might ditch all of their long positions in Treasuries if the 10-year yield reaches 1.02%.
If that happened, the benchmark could quickly jump to 1.2%. The 10-year note hasn’t sold off that much over a calendar week since June.
Jeffrey Rosenberg, senior portfolio manager at BlackRock Inc., said Friday on Bloomberg TV: “93 basis points, 100 basis points, 125 basis points, it’s really about the pace of increase that the Fed will concern itself with.
So if you’re talking about in the next six months, a gradual increase in interest rates, I don’t think the Fed needs to react to that.
What the Fed would be reacting to would be a very sharp rise in interest rates. Certainly we saw that during the taper tantrum — they react to big moves because that’s disruptive to financial market conditions, to financial market functioning.”
Quant freakout notwithstanding, it’s hard to make a ironclad case for the Fed to rush to extend the average maturity of its bond purchases next week.
Across Wall Street, bond traders have been conditioned to expect the central bank to keep short-term rates near zero for the next few years at a minimum and, at least in 2021, not to test the long end too much.
At their November meeting, officials discussed updating their forward guidance on the pace of bond buying fairly soon. That seems like the kind of low-hanging fruit that Powell can build consensus around while advocating for additional fiscal aid to anyone who will listen on Capitol Hill.
If 10-year yields glide upward and exceed 1% as a result of such long-awaited fiscal stimulus, it seems like a tradeoff the central bank would be more than happy to make. The Fed’s threat of yield-curve control is enough to keep the world’s biggest bond market in check.
As the Federal Reserve Bank of New York on Friday was releasing new details about the central bank’s rate-lowering program, some bond-market strategists were already doing their own back-of-the-envelope assessment.
Their conclusion: Operation Twist could in some ways do as much—or more—for the bond market than its predecessor, known as QE2. The program also could prove to be a boost for stocks.
When the plan was announced Sept. 21, it got a resounding raspberry from the stock market. The Dow Jones Industrial Average fell 2.5% that day and had its worst week since October 2008. Stocks have stabilized somewhat since then.
Operation Twist was initially maligned by some market participants because it mainly involves the Fed shuffling its bond holdings, rather than pouring new money into the system. By contrast, QE2, so-named because it was the second round of quantitative easing, saw the Fed pump in $600 billion.
Even though Operation Twist hasn’t begun being implemented, it already is having an impact on long-term interest rates.
It also is affecting what bond investors are buying and selling, pushing many to buy somewhat more risky bonds like mortgage securities and corporate bonds. That’s the outcome the Fed has suggested it wants to achieve.
“Operation Twist has greater punch than the QE2 program, or should,” said Ray Stone, an economist at Stone & McCarthy Research, a firm that focuses on research for the bond market.
Prices on 30-year Treasury bonds have soared on the announcement of Operation Twist, at times driving yields below 3% for the first time since January 2009.
The yield, which moves in the opposite direction to price, has fallen 0.21 percentage point since the day before the program was announced Sept. 21. Ten-year notes also have surged. Yields on both Treasury securities have moved off their recent lows.
Here is how the program works: The Fed will buy $400 billion of longer-term Treasurys—those maturing in six to 30 years—and in turn will sell $400 billion of Treasurys that mature in three months to three years.
Essentially, the Fed is sucking up bonds that have the most risk tied to interest-rate fluctuations. By doing that, the Fed shrinks the supply of those investments available to private investors, which raises the price.
But investors still need bonds with similar interest-rate risk, known as duration, in part because many of them have set duration targets within their investment portfolios.
Barclays Capital and other bond observers measure the impact of the Fed’s buying through a concept known as 10-year equivalents, or the amount of 10-year notes an investor would have to buy to get the same amount of interest-rate risk.
In those terms, Operation Twist looks similar to, or a little bigger than, QE2.
Barclays Capital analysts suggest that Operation Twist will remove roughly $375 billion in 10-year equivalents from the market.
Credit Suisse put that number at $436 billion in 10-year equivalents from the market, more than the roughly $412 billion pulled out of the Treasury market during QE2. Goldman Sachs analysts estimate the impact at roughly $400 billion.
Those numbers don’t count the impact of the Fed’s surprise announcement that it would take the proceeds from its maturing mortgage-backed securities and reinvest them in other mortgage securities, which caused mortgages securities to rally and shrank the gap, or spread, between mortgages and Treasurys.
“Operation Twist is taking the exact same amount of interest-rate risk out of the market, so it should have effectively the same effect” as QE2, said Priya Misra, head of U.S. rates strategy at Bank of America Merrill Lynch.
But bond-market observers contend that the creation of new money wasn’t what gave the QE programs their oomph, rather it was duration the Fed removed from the markets.
Fed officials, including Chairman Ben Bernanke and the New York Fed’s Brian Sack, who runs its market desk, also have pointed to the Fed’s duration removal as a key aspect of how Fed policy works.
As the Fed buys bonds, portfolio managers see those prices rise, tempting them to sell. The managers then have cash, which they use to buy other investments that have better expected returns. To get those returns, they buy something slightly riskier, perhaps corporate bonds.
That pushes corporate-bond prices higher, pushing holders to sell and then buy something else, like higher-yielding corporate bonds. In theory, the pattern repeats itself, causing a ripple effect through the financial markets, pushing up prices of everything, even stocks at some point.
“It will force all money managers to venture into the riskier realm of whatever they’re allowed to invest in,” said Ward McCarthy, chief financial economist within the fixed-income group at Jefferies & Co.
But as Mr. McCarthy points out, the Fed isn’t operating in a vacuum. Worries plaguing financial markets—soft economic data and the prospects for a disorderly end to the European debt crisis—might cause investors to stay in safe assets like Treasurys.
“We look at it in the context of everything. Not just this one item [that] suddenly changes our mind as to how we are going to approach things,” said Bob Auwaerter, head of fixed income at Vanguard, adding that his funds, which have roughly $620 billion under management, are cautious in the current environment. “I would say at this moment, from a risk perspective, we have some risk on but we’re pretty close to home.”
Fed’s ‘Operation Twist’ Tangles Treasury Trade
“Operation Twist” has got the Treasury market in a knot.
One of the goals of Operation Twist, which was implemented in October, was to push investors out of Treasurys and into riskier assets such as stocks.
Under the policy, the Federal Reserve, led by Chairman Ben Bernanke, is buying Treasury bonds that expire within six to 30 years, funding those purchases by selling notes and bonds with shorter maturities.
But economists and traders say there are signs the policy, taken together with the Fed’s pledge to keep interest rates near zero until late 2014, has in fact pushed some investors into competition with the Fed itself.
That is keeping yields on the 30-year Treasury bond lower than many expected, even after taking the planned purchases that are part of $400 billion Operation Twist into account.
With near-zero interest rates squeezing the yields on Treasurys with shorter maturities, bond investors seeking returns are flocking to 30-year Treasurys. But that is usually the realm of buy-and-hold institutions like pension funds and insurance companies.
And expectations for another bond-buying program by the Fed to bolster the economy are also encouraging investors to hold tight to long-term bonds.
This confluence of factors has caused a rapid shrinking of the number of 30-year bonds that are available to trade, and it is also distorting the 30-year bond yield’s role as an important gauge of inflation expectations.
On Thursday, the price of the 30-year fell with a rise in stocks, though the bond recouped some losses following a $16 billion issue. Demand was average but better than gloomy forecasts by some traders.
The 30-year bond fell 31/32 to yield 3.192%. The yield traded above 3.6% in September, prior to the launch of the Operation Twist.
“If the pace of the economic growth continues to pick up, 30-year bonds at these levels make no sense,” said Michael Pond, co-head of U.S. rates strategy at Barclays Capital. “[But] as long as the Fed is active in the market, it is tough to fight the Fed.”
Another sign of the distorting effect of the Fed’s transactions is the shrinking pool of available securities whenever it enters the market to conduct portfolio-shuffling transactions.
The average total value of “sell” offers submitted in those auctions by primary-dealer banks, which trade directly with the Fed and underwrite Treasury debt sales, fell 27% from October to January, to $5.47 billion, according to data compiled by George Goncalves and Ankit Sahni, rate strategists at Nomura Securities.
Meanwhile, the ratio of the total value of the offers to the amount of the Fed’s announced purchases, which stood at three to one in October, dropped to 2.22, the bank said.
This is a sign, analysts say, that institutional investors are sitting on their bonds rather than selling them, thus propping up prices and keeping yields low.
Holding on to their long-term Treasury bonds is “making it harder for the Fed to achieve its purchases without distorting the market,” said Richard Gilhooly, senior U.S. rates strategist at TD Securities in New York.
As part of Operation Twist, the Fed has, since October, gobbled up $50.3 billion in regular Treasurys maturing in 20 to 30 years, acquiring 91% of the gross new bond supply issued by the U.S. Treasury for the maturity range over that time, according to data compiled by Barclays Capital.
And, with improving government finances now expected to allow the Treasury Department to slow its sale of new bonds, that outsize role for the Fed may get even larger.
The New York Fed, which coordinates the central bank’s market operations with primary-dealer banks, declined to comment for this article.
However, at the end of January, it announced on its website that, starting in February, it would increase the number of buying operations to approximately seven a month, from five, without changing the total monthly amount.
The altered schedule aims to “improve the efficiency of these operations,” it said.
There are worries that the end of Operation Twist, scheduled for this summer, could introduce volatility and catch the legions of investors in 30-year bonds off guard.
“If the Fed ends the Twist ‘cold turkey’ at the end of June,” asks Ward McCarthy, chief financial economist at Jefferies & Co., “will long-term rates snap higher? Policy makers will start to think about this before the end of June.”
To be sure, bond yields could remain subdued on their own if economic data in the U.S. start to point to weakness or if euro-zone turmoil again sends investors clamoring for haven assets.
After the Fed halted its second round of quantitative easing—in which the Fed pumped cash into the economy by buying bonds from investors—Treasury yields didn’t spike, because the economy sputtered.
More U.K. Stimulus
The Bank of England said it will buy an additional £50 billion ($79.1 billion) of U.K. government bonds with freshly created money in an effort to shore up the fragile economy.
The central bank said on Thursday that its rate-setting Monetary Policy Committee voted to expand its program of quantitative easing to take the total scale of its stimulus efforts to £325 billion when the latest batch of purchases is complete. The BOE said it will keep the size of the stimulus program under review.
Treasury Curve Dysfunction Ignites Talk of Federal Reserve Twist
* Front-End Rates Are Around Zero While Long-End Yields Surge * Twist Would Kill ‘3 Birds With One Stone’: Bank Of America
Turmoil in Treasuries that has sent longer-dated yields soaring is stoking talk that the Federal Reserve might look to revive Operation Twist in order to reassert stronger control over interest rates at both ends of the yield curve.
Rising expectations about inflation and an unraveling of market positions helped send bond yields surging last week, with the benchmark 10-year rate spiking above 1.6% for the first time in around 12 months. The surge has brought with it sloppy auctions, worsening liquidity and a wider difference between bid and offer prices.
At the same time, there is also concern about rates at the front end potentially going too low, with funding markets hovering around zero amid an abundance of dollars that’s being fueled by monetary policy, fiscal measures and changing bill-supply dynamics.
The phenomena at both ends of the curve represent possible threats to the Fed’s control of policy, and that has observers casting about for potential next steps by central bank officials.
Chairman Jerome Powell and his colleagues have an array of tools at their disposal — for example, a tweak to the interest on excess reserves rate to help control the front end.
But a number of analysts have been recommending the revival of a so-called twist maneuver, which would see it simultaneously increasing its holdings of longer-term debt and reducing its ownership of Treasury bills.
“The Fed is simultaneously losing control of both the U.S. front end and back end rates curves for different reasons,” Bank of America strategists Mark Cabana, Meghan Swiber and Olivia Lima wrote in a note to clients. The implementation of a twist “kills 3 birds with one stone.”
Their argument is that it would help lift rates at the short-end and stabilize yields at the long end, but do so in a reserve neutral fashion that lessens the pressure on banks to hold more capital under the supplementary leverage ratio.
To address market functioning issues, the Fed could initially sell $80 billion a month of bills and concentrating monthly purchases in Treasuries maturing in 4 1/2 years or more, they wrote.
Credit Suisse Group AG strategist Zoltan Pozsar has also recommended the Fed embark on a twist to stabilize yields in addition to offering greater clarity on the supplementary leverage ratio, with uncertainty around that also adding fuel to recent gyrations.
The last time the Fed utilized a twist was in 2011, when the central bank decided to sell shorter-dated Treasuries in favor of longer-dated holdings to help spur the recovery by lowering long-term borrowing costs.
Richmond Fed President Thomas Barkin said in an interview on Bloomberg TV Monday that while the central bank has control of the short end, the long end of the yield curve is a natural reaction to the outlook.
Jefferies economists Aneta Markowska and Thomas Simons said for twist to be a “viable option,” the Fed would have to first focus on stabilizing the front end of the curve, emphasizing the “long road to unemployment and sustained 2% inflation.” They don’t expect the Fed to push back against the back of the curve.
And while Bank of America is busy talking about the need for a twist, they say it might be some time before the Fed also comes to that conclusion, noting that policy makers likely need to see signs of a further deterioration in liquidity and market conditions.
“There will likely be more market pain before the Fed is forced to act,” they wrote.