So, down we go. The last impediment to lower … well … everything (except the $US) has been removed. There’s no QE3. Markets didn’t muck around. Everything risk and $US sensitive took an instant pounding and the $US jumped. The equity market got smashed into the close and is signaling more to come.
What we got from the FOMC was Operation Twist, as advertised. The FT showed some deference in reporting the outcome:
The US Federal Reserve launched “Operation Twist” on Wednesday in a bold attempt to drive down long-term interest rates and reinvigorate the faltering economy.
The central bank said that it would buy $400bn of Treasuries with remaining maturities of six to 30 years and finance that by selling an equal amount of Treasuries with three years or less to run.
“This programme should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative,” said the Fed. The policy is named after a similar attempt to “twist” the shape of the yield curve in the early 1960s.
The Fed also sprung a surprise by pledging to reinvest any early repayments from mortgage securities back into debt issued by mortgage agencies such as Fannie Mae and with a strong focus on buying 30-year Treasuries. “We got a double twist,” said Diane Swonk, chief economist at Mesirow Financial in Chicago.
Such a large move suggests that Ben Bernanke, Fed chairman, is deeply alarmed by the slowdown in the economy and decided to override opposition on the rate-setting Federal Open Market Committee and provide as much stimulus as easily practical. The purchases will run until June 2012, setting the course of Fed policy for the next nine months.
The FT is wrong, this is not big, nor a rabbit out of the hat. As I’ve argued before, at the zero bound, where the only price signal is the signal of policy-maker intentions to deflate or inflate the system, you can’t feed a market rich desserts with thick topping then offer them a dry donut and still expect the system to inflate. Only a bigger dessert with more topping will serve.
I see no reason why both stocks and commodities shouldn’t revert to the prices we saw pre-QE2, roughly 20%+ down for commodities and maybe 15% on the S&P. And that’s before we factor in any recession.
So, what might the “Twist” achieve? Ironically, it may have some effect on the real economy. I can see it achieving two ends. The first is that pancaking the long bond potentially lowers a huge swath of mortgage rates in the US. That may, in turn, fire off a new round of refinancing activity. The following chart from Calculated Risk shows what the Twist is seeking to reverse:
Any such success would free up some more equity in US housing for spending money. Perhaps not a great idea long term but in a world of limited options who cares about that.
The second effect of flattening the yield curve for banks may be to disrupt their very easy carry trade of borrowing short term funds at zero and dumping them into long bonds for an easy margin. By flattening the curve, banks may be forced to lend that money instead.
The deflation in commodity markets (especially oil) should also work to boost demand.
So, we now have a struggle set up between deflation in global market pricing and (assuming it works) inflation of lending targeted at demand. There’ll be some new equilibrium struck between these two.
In theory this looks OK, but the fly in the ointment for me is the $US. With Europe burning and the Fed being seen to be backing off debasement of its currency, the $US must rise. That will slowly choke off the US export recovery and, making matter worse, will exaggerate the downswings in equities and commodities.
The new equilibrium we are about to find is lower.
