A Quick Primer On Why Operation Twist Is QE

Bernanke: Fed stands ready to take further action - 2:24 p.m Wednesday;  Bernanke - 3:01 p.m. Wednesday: Fed will not buy European sovereign debt  (We don't know if this is true or not becaue we don't know how the massive Fed dollar/euro swap program with the ECB is being used.  I suspect Bernanke is lying his ass off and that swap facility is the equivalent of an off-balance-sheet mechanism by which the Fed IS buying European sovs. - Dave in Denver)

Before I go over Operation Twist (OT), I wanted to point out that yesterday's economic numbers released were an unmitigated disaster, further confirming that the economy is tanking quickly.  The Philly Fed economic activity index was reported to be -16.6, vs. the no change expectation on Wall Street:  LINK This actually points toward significant economic contraction.  Furthermore, the jobless claims number was worse than expected and more people are falling of Obama's extended jobless benefits program (the 3 yr deal aka welfare).  Existing home sales dropped 1.5% from April, further confirming my thesis that the housing market is tanking (most of the low-price homes are being sold speculators who are turning them into rentals).  Seasonally, existing home sales should be climbing higher month to month.  Also, the purchasing manager's "flash" index contracted again, with exports plunging below the 50 level, indicating big contraction there.  Look for a much bigger than expected trade deficit to be reported next month for May, which is GDP negative.

Bernanke knows all this better than any of us because the Fed has access to much better data than is filtered through to the public.  Instead of unleashing a full blown QE3 to try and stimulate economic activity and risk being accused of supporting Obama's re-election, Bernanke announced an extended Operation Twist.  Again, in my view, this was imperative in order to continue the Fed's funding of Treasury auctions as a means of preventing interest rates from spiking higher.

The additional OT amounted to a $267 billion extension of this version of QE, which serves to pay for a large portion of new Treasury issuance.  Here's how it works mechanically:  the Fed solicits bids from the primary dealers (big U.S. banks) for the Fed's short term Treasury paper - 1 month to 3 yrs in maturity.  Because there is unlimited demand from short term Treasuries from money market funds and from foreign banks who need the short term Treasuries for collateral use, the Fed knows the primary dealers do not need to use their balance sheets to buy this paper.

Next, the Fed solicits offers from the primary dealers for 6-30 yr. Treasury bonds.  Now, we know the primary dealers own a lot of this paper, as they have been buying anywhere from 25-50% of 7-30 yr Treasury auctions.  If the primary dealers were not using their balance sheets to participate in Treasury issuance, a higher rate of interest would be required to induce the next marginal buyers to participate, and the death spiral of higher Treasury interest rates would commence.  Technically the Fed can claim that OT is "sterilized" funding because the Fed doesn't technically print any money and it's swapping one asset for another.  But because of the dynamics of demand for short term Treasuries, the Fed's OT creates money flows from sources that ordinarily would not be available to buy longer term Treasuries.

Moreover, since the Fed buys the longer term paper off of the big banks, it frees up balance sheet capacity for the big banks to continue their heavy buying of Treasuries at auction.  The Treasury has been issuing roughly $100-125 billion of new issuance monthly.  Between now and the election, the Treasury will likely have to sell an additional $400 billion of new paper.  The OT capacity of $267 billion will enable the big banks to continue funding their share (really the Fed's share) of new Government spending plus gives the Fed some room for injecting some bank liquidity into the banking system for derivatives accidents like JP Morgan's little $5 billion "tempest in a teapot" mishap.

The reason this is a de facto form of QE is that QE accomplishes two goals:  1) keeps the banks from collapsing;  2)  provides the mechanism for the Fed to indirectly finance new Treasury issuance in order to keep interest rates artificially low.  Here's the math on why #2 is crucial:  Assume the Treasury needs to issue roughly $1.5 trillion in new bonds this year.  If interest rates were to ratchet up by 200 basis points on those new bonds (2%), the increase in interest expense to the Government would be $30 billion.  Capito?  You understand?

One last point, without getting into the details because it's Friday and I want think about other things, OT is definitively QE from a theoretical, risk-adjusted standpoint.  Briefly, with the short for long Treasury swap, the Fed is significantly increasing the "duration" of its balance sheet holdings.  By doing this the Fed increases the risk-factor of its Treasury holdings, thereby increasing the probability of losing money on the OT operation.  If the Fed loses a lot of money on its OT bond holdings, it will eventually have to print money to make up for the losses.  On that note, let's refer to the Fed's Operation Twist maneuver as "kicking the QE can down the road a bit, but it's really QE."

Have a great weekend.