Not Much of a Twist!
Yesterday, the Fed announced their intent to repeat a strategy implemented in 1961 called “Operation Twist.” Under the new program, the Fed is going to sell $400 billion in shorter term Treasuries (3 years or less) and use the proceeds to purchase long-term securities, as well as take the payments from their current mortgage portfolio and reinvest them back into mortgages (whereas before, they were reinvesting proceeds into Treasuries). The object is to lower long-term rates to aid the ailing housing market by making housing more affordable. Back in 1961, most economists of the day agree the program had a muted effect, believing to only drop interest rates about 15 basis points.
We believe it will do very little again, not just in moving mortgage rates, but very little to help refinance and/or initiate new mortgages. About ¼ of homeowners are underwater and unable to refinance, and in this environment, you need 20% down payments and sterling credit to obtain a new mortgage – lowering mortgage rates won’t change that. On the other hand, it’s creating two other risks – it’s increasing the exposure of interest rate risk on the Fed’s balance sheet as their fixed bonds have longer durations, and it’s reducing banks profitability as the yield curve flattens (as much as banks may try to match short term deposits with short maturity investments, and long with long, they often end up with mismatches which is why they tend to struggle when rates move quickly and the yield curve flattens).
The Fed has two mandates: 1. Keep inflation in check and 2. Create an environment for economic growth. Lowering long-term mortgage rates is not going to spur growth but the Fed’s policies have been opening the door for inflation to become a very serious problem. The Fed is running out of tools to help a sick economy. We would rather have seen steps taken that would help strengthen the banking system, which may mean taking no steps and simply letting the economy heal, even if that’s a bit painful in the short run.
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