The Yield Curve Twist

In 1961, John F. Kennedy had an economic dilemma. Facing a recession, how could the U.S. spur long term demand without lowering interest rates, which at the time, would’ve placed the U.S. in the position of lender to the carry trade. The lender in the carry trade is the patsy due to a weak domestic currency and a bleak economic forecast. President Kennedy was no patsy. The plan they put into place was called, “Operation Twist.” This involved the Federal Reserve selling short-term credit and buying long-term. Remember that prices and yields run opposite to each other. Therefore, the more short-term paper the Fed sold, the lower they forced prices and the higher short-term yields became. Conversely, the more long term paper they bought, the more it pushed up prices and lowered the long term yield thus, flattening the yield curve.


Fast forward to 2011. The Dollar is sagging, short term rates are near zero, QE1 and QE2 have passed and we still face a general lack of demand as our country works through the deleveraging process in an effort to right the ways of fifteen years of over spending. Our Democratic President is up for re-election and needs something to spark his domestic relevancy. I understand that the Federal Reserve and the Executive branch conduct their policies independently with the same target of the greater good and I’m not suggesting collusion or conspiracy theories – just noting the timing of conjuring a fallen hero’s memory.


So, what’s it mean? There are several positive factors to this policy. First of all, unlike the Quantitative Easing Programs, Operation Twist won’t expand the Fed’s balance sheet. This plan doesn’t create more debt; it simply lengthens the maturity date of the debt portfolio as long as the short term sales match the dollar amount of the long term purchases. We can probably agree that not increasing the current debt level is a good thing. Extending the maturity date of our debt portfolio also makes sense at historically low interest rates. It’s kind of like the U.S. is going to refinance their house.


This process is also designed to strengthen the Dollar. Currency trading is basically short term arbitrage between interest rates and economic outlooks of the currency pairs being traded. Selling short term paper in the markets keeps short term rates higher which strengthens the U.S. Dollar. Higher short term rates will be very helpful to money market programs and retirees looking for yield. The strengthening U.S. Dollar can then be advantageously used to repay debt previously incurred at lower costs. The strengthening Dollar will also help to mute inflation sensitive commodity prices once the economy gets rolling again. Finally, a stronger Dollar will make us less likely to be the global patsy lender in the carry trade.


The commercial traders have already forecasted the moves in the markets. The changing shape of the yield curve can be seen in the sell off of the Eurodollar complex. This short term vehicle’s current yield of nearly 0 projects out to March of 2012 with a rate of nearly .4%. This coincides with a rise in yield on the 2 year Treasury Note of nearly 7% from where it was only one week ago. Meanwhile, the long bond has exploded to new highs in price equating to an all time low yield of 3.152%.


The general purpose of this move is to change the shape of the yield curve. Banks make money by borrowing cheaply in the short term and lending at higher rates in a longer time frame. The effects of Quantitative Easing and the TARP programs  provided a very favorable banking yield curve coming out of the ’08 collapse. In fact, it was the financial stocks that led us out of recession (and maybe caused it?). This move will decrease banks’ overall profitability in the near term but should fuel longer term business and consumer lending without increasing the overall debt levels.



This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.


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