Operation Twist? What The Hell Is That?

"A socialist eventually runs out of other people's money" -  Margaret Thatcher

Someone asked me what the hell Operation Twist was this morning.  It's essentially one of the Fed's "tools" that it thinks it can use to try and stimulate the economy by making a concerted attempt to lower medium/long term interest rates and stimulate housing and business borrowing.  The way it works is the Fed will attempt to "flatten" the Treasury yield curve by going out and buying up Treasury bonds in the middle and long part of the Treasury curve (5-30 years, mostly in the 7-10 range where mortgage rates are based). 

In researching the topic in order to make sure I wasn't oversimplifying or erroneously describing what it is, I googled the term and came up with an interesting link about Operation Twist from Nowandfutures.com which attributes this "Operation Twist" idea back to the Kennedy Administration and its desire to get interest rates lower in order to lower the balance of payments deficit at that time.  Here's the essay for those interested in the historicity of fiat currency and Government/Fed intervention in the markets:  LINK

In a "twist" on the methodology used by the earlier Fed, which sold short term Treasuries and bought long term Treasuries, I'm surmising that the Fed this time around will try to pull down interest rates and flatten the curve solely by buying the longer paper.  I say this because it already has in place a zero-interest short term rate policy thru 2013, and thus I do not expect the Fed to be unloading short term paper. You will hear some fancy lingo like "increase the duration" of the Fed's Treasury portfolio, which simply means the Fed is letting the shorter term holdings mature and it's rolling that money into intermediate/long Treasuries.

Does this mean that it's time to buy longer-maturity Treasuries?  No.  Like any other publicly traded market, the information that the Fed will likely do this is largely already priced into the market.  Don't you think, given the amount of "telegraphing" that's been done on this - and the fact that Pimpco's Bill Gross has said he may buy intermediate Treasuries after dumping all of his Treasuries six months ago - that the big institutional money has already anticipated the Operation Twist event?  In fact, this will be a money-losing trade for the Fed/Taxpayer because, in all likelihood, we are at the bottom of this secular interest rate cycle and at some point the price/yield of Treasury bonds will reflect the true rate of inflation and dollar devaluation that is coming. 

Moreover, the Chinese and other big Treasury holders will likely use the Fed bid as an opportunity to dump big blocks of their holdings into the market, as they continue to make good on their publicly stated promise to diversify away from holding U.S. dollars.

I'm assuming the inquiry referenced above occurred because someone received a call from either their broker or their genius financial advisor who said now is the time to buy longer-maturity Treasuries in order to pick up some extra interest income and take advantage of the highly anticipated Operation Twist implementation.  Sorry, it's too late.  If your broker tries to sell you an intermediate Treasury ETF like TLT, hang up.  If your financial advisor tries to convince you to buy Treasuries, tell him to move you into cash so you can move your account to someone who understands gold.  Be careful because this Fed operation will be a marketing tool used by brokers to try and generate commissions.  By the time retail brokers/advisors are trying to unload ideas on the public, it means the parent financial firm has already positioned the security and is now looking to book profits via the retail distribution network (brokers/advisors).

Circling back to the original question leading to this blog post, this is how I answered:

"Operation twist" is an attempt by the Fed to lower medium/long term interest rates by pegging the short term rate to zero and then going out and buying longer-date Treasuries. It's meant to be an extension of QE2 and supposedly can be implemented without the Fed having to expand its balance sheet (printing money). It's called a "twist" because the yield curve is normally upward sloping - i.e. the longer the maturity of Treasury bond, the higher the yield. But the idea is that the Fed can "twist" the yield curve into a "flatter" shape.

What's going to happen next? 1) Obama announces a $1 trillion infrastructure spending program. 2) Obama also announces that the Govt will use Fannie Mae and Freddie Mac to refi $1 trillion in troubled mortgages at 4%.  3) It just so happens that the Fed has $1 trillion in FNM/FRE mortgages. Those get refi'd and moved back to the FNM/FRE/Taxpayer balance sheet and it enables the Fed buy $1 trillion in longer-dated Treasuries to try and lower rates.  4) The Fed at its next meeting Sept 21-22 announces some sort of new QE. My bet is they need to inject massive liquidity into the collapsing banking system and will buy more crap assets from banks and the Fed will also need to expand its balance sheet to pay for Obama's new spending program.

Obviously it won't unfold exactly like that but that's the basic format and Obama and the Fed have already telegraphed something like that. For example take Obama's speech to the huge crowd of welfare/union entitlement recipients in Detroit yesterday and assume that's what he's going to announce Thursday night while most of us click the cable box between the NFL season opener and the U.S. Open tennis tournament. The Fed will have to come up with a way to pay for Obama's program and that will happen at the FOMC meeting.

Gold and mining stocks are going to be volatile BUT they are going to go a lot higher within the next month or two.