The twist is on. On Monday, Ben Bernanke launched his latest effort to boost the economy. The stock market, for one, seems skeptical it will work.
The plan, which has been dubbed Operation Twist, is for the Fed to cash out of $400 billion worth of its short-term bonds and replace them with long-term debt. The first move came Monday morning when the Fed bought $2.5 billion worth of long-term U.S. Treasury bonds. The Fed has been buying U.S. Treasury bonds ever since the financial crisis in an effort to drive down interest rates and boost lending and hopefully the economy. And it greatly stepped up its buying last year in a controversial move that came to be known as QE2. What’s different this time is the Fed is buying longer-term bonds. Past plans had focused the Fed on buying bonds that would come due in 5 to 10 years. On Monday, the bonds the Fed bought won’t be come due until 2036 at the earliest. Others won’t be paid back in full until 2041.
Lower rates in general make it cheaper to borrow, and therefore encourage people and companies to do so. At least that’s how it’s supposed to work. The Fed has held short-term interest rates near zero for more than two years, but borrowing is still down. Enter the twist.
The name of the plan comes from what Bernanke hopes the plan will do to the yield curve, which typically slopes up. Short-term bonds have the lowest interest rates. Long-term bonds, further out on the curve, have the highest ones. The plan is to flip that around, or at least flatten the curve, so that long-term rates go down, and short-term rates rise. The longer you can lock in those low rates, the cheaper it is to borrow. And so the Fed hopes that lower long-term rates can do what near zero short-term rates have yet to produce – a real boost to the economy.
How’s it working so far? It is, of course, too soon to tell if the plan is boosting lending. Yields on 10-year bonds are down slightly from where they were before Bernanke announced the plan nearly two weeks ago, and 1-year bonds are up slightly. So far so good. But if you go by the stock market, however, Operation Twist has been a bust. Stocks fell on the day Bernanke announced the plan. In keeping with that, the Dow Jones industrial average fell another 258 points on Twist’s first day – though the debt troubles in Europe are weighing on the stock market as well.
As I predicted a few weeks ago, Operation Twist’s Achilles heel is the banks. And indeed, bank stocks have sunk along with the rest of the market. Problems at Morgan Stanley, Bank of America and other banks are raising concerns that we could face another financial crisis. A flat yield curve will only make it harder for banks to make money. My bet is that Operation Twist will have a mildly positive affect on the economy. Nothing huge. Part of the boost QE2 provided came from the stock market, which rose when the plan was announced, and continued to do so for some time. Seems like Mr. Market isn’t willing to put out twice for Bernanke – a twist, perhaps, the Fed chair didn’t count on.