Where will rates go once the FED stops meddling?

March 15th, 2012 by

(March 2012)  Since 2008, the Federal Reserve has been interfering with interest rates to a degree which is unprecedented in my lifetime.

In the early 80’s, The FED under Paul Volker raised rates to sky-high levels, creating a recession in order to kill inflation.  However, that was done with traditional policy tools such as the discount rate and the FED Funds rate. Recently, the FED has used new policy tools.

This is not a political article; I am curious if there is an opportunity to make money from understanding the impact of these new tools.

 

What happens when the FED stops using these new tools?

In recent meetings, the FED has announced that it does not plan to take any action to raise interest interest rates until the end of 2014.  As we approach 2014 however, this implicitly means that they will cease using these new tools.  This should have a huge impact on the markets, and in particular the fixed income market, which presents an opportunity for investors.

 

What tools am I talking about?

Quantitative Easing & Operation Twist

Quantitative Easing – Simply put, quantitative easing is flooding the economy with money. Since 2008, the fed has pumped $2.3 trillion into the economy. How has this been done? The Federal Reserve buys Treasuries in exchange for cash. The FED is basically printing money and buying treasury bonds with it.

Operation Twist – The FED is in the process of  buying $400 billion of Treasury bonds with longer maturity dates and selling bonds with shorter maturity dates.  The difference here is that the FED is taking some of the money that they pumped into the economy back out by selling the bonds with shorter maturity dates. The FED estimates that this will push up the average maturity date of its holdings from 75 months to 100 months.

 

What was the effect of these moves?

Jack Meaning and Feng Zhu do a great job of answering this question in their paper entitled: The Impact of Federal Reserve Purchase Programs: Another Twist.

According to the report, Quantitative Easing reduced the yield on the 10 year treasury by 1.64%, and Operation Twist reduced the yield on the 10- Year Treasury by an additional 0.85%.

For every one month change in the average maturity date of Treasuries held by the Federal Reserve, the 10- Year Treasury moves by 0.032% (3.2 basis points). According to their research, if the FED did not buy or sell Treasuries in the 12 months following the end of Operation Twist, the yield on the 10 year would naturally rise .384%. The maturity of the FED’s portfolio would be 12 month’s shorter.

 

That was my big aha moment.

Once operation twist ends in june, the benchmark treasury will naturally rise 0.4% per year because of the change in the average maturity date of the treasuries they hold.

Everyone is focused on what the FED plans to do with interest rates, meaning the FED FUNDS rate. For Treasury Yields to rise however, the FED does not need to change the FED FUNDS rate or even sell the massive amounts of the Treasuries it owns. If they simply allow the maturity dates of the treasuries they hold to naturally shorten, the 10-year Treasury could rise significantly.

The Fed Publishes maturity date data on its treasury holdings once per week. While the data is somewhat vague (I think on purpose), it does give you some indication of its holdings. If the FED chooses to let the average maturity of the treasuries it holds shorten, their holdings with maturities between 1 to 5 years should increase a bit, and their holdings with maturities over 1o years should decrease a bit starting in June. If this happens, it provides another reason to sell long dated treasuries.

Its important to note that the FED is talking about taking further measures to keep yields on longer-term bonds down, and the threat of further action itself is a deterrent to rising rates.  There is a limit however to how much talking the fed can do before the market tests pushing rates higher. My belief is that the FED will not take further action.

 

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