Friday, June 22, 2012

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.


  1. This economy is History. Get your gold and silver while it's cheap!

  2. Hey Dave,
    For over a year now, I have been hearing Sprott, Turk, Rule, and others on King World News and other outlets saying a price explosion in gold and silver is imminent. To be honest, I am getting really tired of these predictions since it has been nothing but hype and 100% wrong. I was an avid listener of Bob Chapman before he passed and even he was wrong. The cartel controls the price. I never thought silver would be at this level 13 plus months after the May Day raid. Do you think anything will change in the next 6 months, or will it be more of the same? It seems no matter how bad things get here and in Europe, the prices of Ag and Au go down. It is so frustrating, especially seeing myself get more in the red with my stocks I wonder why bother, just get out and go all physical. Your thoughts on the short term is appreciated.

    1. Bob Chapman was usually either very wrong or way ahead of the curve.

      A price explosion is coming in the metals. Because of the extreme manipulation, which gets worse as time goes by because the Government refuses to enforce the laws, it's impossible to nail down the timing. I rarely will make timing or price level calls.

      Because we are in a seasonally weak period for the metals, I would expect move upward movement from here until late August, when the Indian gold buying seasonals kick in. When I say "from here," I mean a move up and over $35-36 for silver and over $1800 for gold.

      With bullion, you have to keep buying a little every month or whatever fits your budget. Mining stocks? Again I can speak to the timing of the next move higher, but it will be a very big move.

      As Sinclair likes to say, if you can't take watching this market right now, crawl under a rock and only peak out once in a while. Sit tight and be right.

    2. One more point. As the old adage goes, a bull market likes to shake off as meany investors as possible before making its next move higher. We are near the end of the latest correction and it is shaking very hard. The sentiment is in the pits and a lot of people have thrown in the towel. The major price corrections during this bull have lasted, on average 12-18 months. We are about 14 months into this correction. The longer and harder this market "shakes" off investors, the bigger and better will be the next move higher.

    3. @Anonymous:

      I too was sick and tired of Sprott, Turk and all the rest predicting price movements and consistently being wrong. So I now refuse to listen to any of their price predictions. All I do now is stack physical gold (and silver).

      My plan is simple now: to have more ounces at the end of the year, then I did at the beginning of the year.

      -Sicilian Gold

  3. Thought provoking piece by Hugo Salinas Price.

    The Matrix of Power
    Hugo Salinas Price

    “The thing that hath been, it is that which shall be;
    and that which is done is that which shall be done:
    and there is no new thing under the sun.”

    Ecclesiastes 1:9

  4. Great explanation, Dave, of how OT converts 'outside', latent demand for short-term Treasuries into 'realized' powder for the Fed to buy long-term Treasuries.

  5. Gold is firmly nailed to the "QE to infinity" cross.

    This cross was the mantra provided by the goldbugs themselves.

    Perhaps Goldbugs will evolve someday from this debate and realize that this isn't the issue anymore. Yes or no to "new QE", silent or otherwise, is totally irrelevant anymore. The only difference between the two is the time of flight. At least there are some - not so well known people - who have progressed beyond this rediculous QE mantra. Alisdair Macleod interview with Charles Goyette. And another, original, research report (older) at least has also done more to progress this debate. "In Gold we Trust" by Standard Chartered in Hong Kong. There the supply side is researched and the biggest take away is that new Gold Projects need a Gold price of at least 1400 dollars for finance, so what would that mean????

    And the GotGoldReport about longterm charts just confirms that these charts show one thing that the miners are invested by traders and not investors.

    I will watch this progress and we will probably see Jim Sinclair change his tune about "QE to infinity" - not because the central planners want to do it so badly but because they will be stopped by revolutions before that happens - unless something happens like the SEC said give every American 10mill to spend - only that will save banks.

    Reverse QE will happen before "QE to infinitiy" and that is all debt will be wiped clean.

    Gold is a ponzi scheem - like everything else in present day "investing" - the ponzi is demand and supply.

    1. You are a good example of someone who likes to rant and pontificate subject matter about which you know nothing

  6. Unfortunately another point about the irrelevance of QE and the issue about Germany to agree or not agree to bailout Europe. Either way Germany is in the shit because the German Banks thought they could buy the whole of Europe already - it's done - no way to return.

    According to this youtube "article" it shows that German banks are the most levered in the world at over 30. So Greece knows they can take Germany down either way - in fact Greece is in a stronger position to negotiate. The old saying - owe a bank 10k and it is your problem - owe a bank 10bill and it's the banks problem. And so it is in Europe - it isn't Greece's or Ireland's or Spain's problem anymore.

    So curtesy of German Banks - Germany is fucked either way.

    In this youtube it also note PIMCO's comment of France being levered 100 to 1.

    So it support my point that by now QE is absolutely and totally irrelevant.

  7. Dave,
    Why is it all the people who make no sense and can't explain themselves (ie total lack of communication skills) dis gold?
    Germany may be fucked, but so is the US and many other countries. China and my country, Canada, have printed a lot of money, too. My dollars have lost 23% of their purchasing power in 12 years. At the same time, I have "money" in a special tax-free savings account and it has grown by 2.5% in 3 years. DO the math. Why wouldn't I invest in real money when fiat offers returns like that?

    Justin from Canada

    1. I gave up trying to understand the mind of a moron a long time ago...