Thursday, September 22, 2011

Tropical Storm Ophelia and Fed Operation Twist: Which will be more damaging to the US?

The track of Tropical Storm Ophelia and the announcement by the Fed of Operation Twist is a classic example of potential versus reality!

Potential: Based on a variety of environmental factors, what is now Tropical Storm Ophelia may or may not ever have any impact on the US. As the models currently show it may miss us completely.

Reality: The Fed announced Operation Twist yesterday which will be a reality that may unfortunately be detrimental to a great many Americans!

The two basic premises of Operation Twist are that the Fed; a) will sell $400 billion of 3 year or shorter maturity treasuries it owns and use those proceeds to buy treasuries with maturities 6 years or longer, and b) the Fed will reinvest payments it receives from mortgage debt the same way.

The idea is to push long interest rates down with the thinking that it will create demand for borrowing and investment. If the Fed hasn't noticed, interest rates are at historically low levels now and that hasn't done the trick.

Why does the Fed believe (or do they believe) that this will work? Or, was this move mostly symbolic and an indication that the Fed is acknowledging that it may be out of bullets?

What the Ivory Tower boys in Washington don't seem to grasp because they are insulated from the realities of the actual, day-to-day economy, is that it is the poor psyche and emotion of the people that is the problem.

That coupled with the fact that if a good investment opportunity actually is found, the banks continue to refuse to lend.

Possibly though the Fed understands it all too well but is helpless at this point to create any policy that would truly aid this struggling economy (although its past policies haven't helped either)!

Consequences of Operation Twist

  1. The spreads between municipal or corporate bonds to Treasurys will widen. Yields on munis/corps will go down , but not as much as Treasurys (there isn’t a growing risk of sovereign defaults as with munis).
  2. Bond speculators (is there any such thing as a genuine saver who has been buying 30-year bonds to hold for three decade?) will be rewarded with capital gains.
  3. The capital that goes to bond speculators comes out of the capital accounts of the bond issuers. It’s a zero-sum game. When interest rates rise, bond speculators lose and bond issuers gain. When rates fall, the opposite.
  4. One of the banks’ (illicit) source of risk-free profits is reduced. Yield curve arbitrage, borrowing short to lend long, will become less profitable.
  5. Where bond issuers have access to the markets to “roll” their liabilities, the new payments will be lower. In theory this would allow them to borrow more (which is what the Fed intends). In practice, we shall see. Certainly governments will borrow more, as there is little or no personal downside to the politicians who make such decisions.
  6. Any borrowing that only makes sense because the interest rate was further reduced is, almost by definition, malinvestment. Such borrowings will not be paid back. Car buyers would do well to consider the total cost of ownership over the life of that 84-month 15% interest loan with the balloon at the end and “affordable” payments. The same is true with government and corporate borrowers: there are other considerations than monthly payment.
  7. Assuming any business does borrow at the new, lower rate, it will have a permanent competitive advantage over its competitors who borrowed at the old, higher rate. The new borrower will either be able to produce the same good at lower cost (due to lower debt service) or be able to attract customers to the new restaurant, hotel, resort, cruise ship, shopping mall, etc. Customers love higher ceilings, lavish landscaping, opulent gilding dripping from the marble columns, etc.
  8. Thus capital destruction will continue and accelerate.
  9. The process of halving of interest rates will continue. It is just as damaging to go from 1.5% to 0.75% as it was to go from 12% to 6%.
  10. Debt accumulation will continue.
  11. All, of course, until it cannot continue.

Before you go, look below! Connect with The Political Commentator on social media!

Follow Michael on Twitter

Friend Michael on Facebook

Connect with Michael on LinkedIn

Subscribe to TPC right here!

Enter your email address:

Delivered by FeedBurner

Subscribe in a reader
Enhanced by Zemanta

No comments :

Post a Comment