Operation Twist – What the Fed May Announce Today and the Implications

The Federal Reserve is likely to announce additional easing measures at the conclusion of the two-day Fed meeting today. Additional easing is anticipated by the market but there are a number of uncertainties related to the scope of what the Fed will implement. The most focused on initiative is called “Operation Twist” which is jargon for selling shorter-term Treasury note holdings (which are yielding a number of basis points which can be counted on one hand) and reinvesting the proceeds out the maturity curve. The action has the effect of increasing the duration of the Fed’s treasury holdings and effectively taking duration out of the market. The System Open Market Account (SOMA) is the account where Fed purchased securities reside. It has been estimated by Brian Sack’s New York Markets Group (New York Fed) that between 20-40% of the impact from QE was based on maturity lengthening (increase in duration) with 60-80% of the QE impact from outright purchases. Just lengthening the maturity through the reinvestment of the MBS Security runoff would have the impact of lengthening the maturity of Fed holdings and providing a QE3-lite. The larger impact of implementing Operating Twist would have the potential to increase duration much more dramatically as you get both reinvestment of the MBS portfolio runoff and outright sale of short dated treasuries with repurchase of longer dates maturities. If the “TWIST” is implemented in sufficient size it could have a comparable impact to QE2 ($600B).

Twist has the potential to support markets today if the initiatives announced at the conclusion of the Fed meeting are “larger than expected”. It will be important to monitor the size of the program announced and how far out the maturity curve the Fed will go. Additional announcements could relate to decreasing the interest rate on excess reserves that the Fed pays from 25 bps to some lower number. Lastly, a wildcard which would likely be perceived positively would be if the Fed announced the resumption of mortgage backed security purchases as part of the SOMA program. This would be a positive to the extent that mortgage rates continue to decline, potentially hitting sub-4%. In theory this could help household budgets through another refinancing wave. Of course there would need to be banks that provide the refinancing but Obama is working on facilitating this through national programs such as the Housing Assistance and Recovery Program (HARP). If rates were reduced and housing refinancing facilitated it could also help support and stabilize the value of our nation’s housing stock which many economists believe is close to bottoming anyhow. All of these outcomes are the best possible outcome the Fed can hope for. The above is worth keeping in mind while reading through the Fed statements and minutes in order to understand their motives and goals.