Twist of fate
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Last month, the US Federal Reserve announced its latest attempt to boost the faltering US economy, Operation Twist.
Rather than introduce more quantitative easing to increase money supply, this stimulus package aims to tackle long-term interest rates. However, many investment experts doubt the effectiveness of the measure and believe a further round of QE may be just round the corner.
Under Operation Twist, the Federal Reserve will sell $400bn short-dated US Treasury bonds, of three years’ duration or less and purchase an equivalent amount of Treasury bonds dated between six and 30 years’ duration.
This is intended to reduce longer-term interest rates and make conditions easier for businesses planning for the future.
The Fed has set a timescale of between now and next June to complete the operation.
According to Ignis Asset Management chief economist Stuart Thomson, the latest economic support programme is an improvement on the last two instalments.
He says: “It is a necessary step, given the poor construction and implementation of both QE1 and QE2. It is designed to lower the term structure of interest rates to levels that are attractive for corporations to increase investment in long-term productive assets and escape the paradox of thrift.”
However, Thomson warns any effects of the initiative will not be felt immediately.
He says: “Companies have been hoarding cash on their balance sheets and investment as a percentage of profits has fallen to multi-decade lows. This reflects corporate liquidity preference in the wake of the credit crunch.
“This risk aversion will not dissipate in the near term, particularly when there are concerns over the European sovereign debt crisis and the Fed’s own warnings that growth remains slow.
“Operation Twist is an important stimulus but the economic impact of it will take time to prevail.”
M&G fund manager Richard Woolnough has welcomed the fact that the Federal Reserve is looking at new policy initiatives.
Woolnough says: “Let’s hope Bernanke’s unconventional twisting of the yield curve turns out to be a net positive policy response and not twisted thinking.”
However, he warns this unconventional approach could have the opposite effect to the one intended.
He says: “The flattening of the yield curve caused by the twist and the pre-emptive shout from Bernanke that rates will be kept low until mid-2013 will harm the banking sector.
“The flat yield curve and the anchoring of short-term interest rates will reduce the positive cost of carry that banks can earn, handicapping the banking system when the current crisis has the banks at its very epicentre.
“Additionally, by flattening the yield curve via unconventional policy actions, the leading indicator of economic growth - the Conference Board Leading Economic index - will point to a weaker economy.
“This might deter business planners who have historically looked at this indicator to assess the health of the economy and cause them to reduce or defer potentially stimulative investment plans. This will act as a drag on growth, which is precisely what the Fed is trying to avoid.”
Standard Life Investments head of global strategy Andrew Milligan goes further and says this initiative will not make a great deal of difference and the Fed would be better off boosting money supply to get the US housing market moving.
Milligan says: “If Operation Twist is to have a positive effect on the US economy, the main channel should be through cheaper money, especially lower mortgage rates.
“There should be a boost to consumer spending as mortgage refinance and housing activity picks up.
“The danger with the Fed’s latest form of QE is that it is falling into a classic trap and making the same mistake it made back in the early 1930s during the Great Depression.
“The Fed is overly concerned with the cost of money, bond yields and interest rates and not sufficiently concerned with the quantity of money, whether measured in terms of money supply and credit growth or financial conditions. We fear Operation Twist will be a failure.”
Thomson also agrees that the problem is not due to the lack of demand of borrowing but to a lack of willingness of banks to lend. He warns the latest move could damage banks’ willingness to lend and says the next round of QE will have to follow soon.
Thomson says: “We do not believe the solution to excessive excess reserves is to cut the rate of interest on these reserves. Banks are more likely to pass on these lower interest rates to the detriment of money market funds that are major suppliers of funding to European banks, exacerbating the sovereign debt crisis.
“This means the Fed will have to pursue QE3 despite the irrational objections of Republican politicians and mercantilist central banks. We believe the central bank will deliver this unlucky news on December 13.
“The size of this operation should be greater than the $800bn gross flows under Operation Twist and the $600bn enacted under QE2. Indeed, the size should be greater than $1tn.”
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