A policy with a Twist

The FOMC minutes are out and it seems the committee of US rate setters is no longer unanimous on the issues. An extension of Operation Twist was the compromise outcome and there is a reason for that. And in addition, they softened the language even more by the previous commitment of rates on hold to at least Spring 2014 changing into at least Spring 2015. Note that this was a necessity in order to limit shocks on the front end of the curve (the "sell" part of Twist). On further active policy intervention - quantitative easing 3.0 - the minutes gave 2 opposite comments (and hence the sterile non-expansionary twist as an outcome) :

1) A few members expressed the view that further policy stimulus likely would be necessary to promote satisfactory growth in employment and to ensure that the inflation rate would be at the Committee’s goal. Several others noted that additional policy action could be warranted if the economic recovery were to lose momentum, if the downside risks to the forecast became sufficiently pronounced, or if inflation seemed likely to run persistently below the Committee’s longer-run objective

2) Some members noted the risk that continued purchases of longer-term Treasury securities could, at some point, lead to deterioration in the functioning of the Treasury securities market that could undermine the intended effects of the policy.

So point 1 leaves the door open. Point 2 means that some within the FED are finally becoming aware of the very nasty counter-productive side effects its intervention has been producing, but we will tackle this later on (see also our blogposting of 04/07 http://www.econoshock.be/a-question-of-safe-assets-the-paradox-of-unconventional-monetary-policy)

What has happened since the announcement was made ? Underlying graph depicts the move in the US Treasury market since 20/06 where we see so called "bull flattening" of the curve, meaning that the long end (10-30y) moves lower and this to a higher degree than the front end (2y) .

And crunching some numbers of total US Treasury holdings world-wide, it seems that the FED, the BoJ and the Bank of China are holding some 40% of the US public debt market. Which means that US budgetary policy - or more precisely US public funding conditions - are now determined by 3 major central banks.

So far so good. Well, may be not because operation Twist comes with several twists :

1) By law, the FED cannot hold more than 33% of a specific bond emission. Now when we take a look at their present holdings after Twist 1 came to an end, we come to something like this

7 - 10 year maturity bucket : 31,2%

10-25 year maturity bucket : 30,4%

25-30 year maturity bucket : 24,5%

So operation Twist - or even a future new expansionary round of quantitative easing meaning printing out of the blue - has no legs to run (except the very long end of the curve). Unless of course the US deficit (-8%) remains unchanged or worsens, or the law on maximum holdings is changed, lifting the bar for example to 40%. Whether both issues are desirable medium term policy objectives - increasing balance sheet duration risk and debt management - is something else of course.

2) And this is the argument of the FOMC dissidents : the policy is destructive for the working of financial markets. Or, "Sire (Ben), we are running out of collateral here". Financial players are being deprived from useful pledgeable instruments when doing business with each other, enforcing deflationary tendencies and deleverageing. In Europe it's a kind of similar situation where some 40% of the Euro-zone government bond market (Italy, Spain, Ireland and Portugal) is no longer a preferred collateral to do business with, hence the panic buying into core bonds @ zero or negative interest rates. It's all pretty understandable. Is it a welcome evolution ? Probably not but we let history be a judge of that. My guess we will see a lot of books appearing on this subject over the coming years, once the "real" effects will play out.