Bill Gross released a very troubling tweet earlier:
Why is it odd? Because as David Rosenberg predicted two weeks ago when he expected that Operation Twist could be coming back with the Fed "capping" the 10 Year, Bill Gross, who has Larry "Fed Expert Network" Meyer in his ear and thus knows better than most what is coming, is predicting some "Twisting" though not at the 10 Year mark, but at the very short end. This is very disturbing. Because as we suggested at the end of May, QE3 will in reality be Operation Twist 2...
This means that Rosie's prediction that "the Fed would basically lose control of its balance sheet" could be about to come true, and in fact be far worse than expected, because it would mean that not only is the Fed no longer able to control the 10 Year but is concerned about controlling the 2-3 Year sector, a place on the curve that the Fed chairman has typically never had much to worry about.
Incidentally, we wondered earlier why not a single OTR 2 Year bond was tendered to the Fed during today's POMO. Here is you answer: why sell today at 0.44% when you can wait a month and sell them back to Brian Sack at 0.00%
Below we repost the article from May 31, as this topic may suddenly be everything that people are talking about.
It is no secret that to a deflationist like David Rosenberg bond
yields have to go lower... Much lower. With the 10 Year flirting with a 2
handle one would think he would be content. Alas no. In fact, as he
suggests in his piece from today, Rosie is convinced that the next
iteration of QE will be nothing short of a redux of the 1961 initiative
to kill the then gold exodus known as "Operation Twist" (recently dissected
by the San Fran Fed). Incidentally it was the same Fed that compared
QE2 to Operation Twist. It is only logical that Rosie would then suggest
that QE3 would be nothing short of a complete clearing of the 10 Year
bond in the market via the Fed in order to anchor expectations that the
10 Year rate would never go up (or reasonably "never") in the
biggest gamble of all: that the Fed will attempt to both control its
balance sheet and target Long-Term interest rates, a mission doomed to
fail...But not like that will prevent the Fed from setting off on such a
mission, especially following today's official confirmation of the
Housing Double Dip (someone page Jim Cramer). As Rosie says: "Now it is
doubtful that the Fed would ever target the long bond. In fact, the Fed
may even want it to be higher in yield to ease the pressure on radically
underfunded pension funds. While the Fed can either target its balance
sheet, which it has been doing with these QE measures, or target
interest rates, it cannot do both at the same time. So the next 'QE' will not be called 'QE' but rather something else — maybe Operation Twist 2 (OT2 — you heard it here first). The Fed would buy up all the 10-year notes needed to clear the market at the target "price" (yield). So depending on supply conditions and demand from the private sector, the
Fed would basically lose control of its balance sheet, but if in return
this policy is the one that blazes the trail for a turnaround in the
housing sector and a durable revival in the economy, so be it." And keeping in mind that the true unspoken reason for Operation Twist 1
was to terminate the outflow of gold from the US to foreign bank
vaults, we find ourselves agreeing with Rosie that an insane idea such
as OT2 is precisely what the Fed would do to avoid a recurrence of the
1961 gold exodus (and attempt to give housing one last failed boost). As
many birds would be killed with one stone, the only downside, that of a
complete balance sheet implosion following OT2, certainly seems quite
acceptable to a central bank now officially run by sociopaths.
From Breakfast with Rosie:
just about everything that has to do with the economy is either
directly or indirectly priced off the 10-year part of the curve, it
stands to reason that this is the segment that matters most for the
economy. The 10-year part of the curve is the oxygen tank for
the market and macro backdrop, yet the Fed in its latest QE round
centered its efforts more on the front- and mid- part of the curve.
is little doubt that the housing market is suffering from a variety of
obstacles, but what is clear from the consumer survey data is that households do not believe that interest rates will come down any further.
The Fed can only do so much to deal with a de facto vacancy rate of 10%
for the homeownership sector (double the norm) but every little bit
helps at the margin and certainly it can do a much better job at
influencing affordability levels to stimulate some demand growth.
need to be convinced that once they make the decision to finance a
purchase that they won't run into a period of rising rates that could
impede their debt-servicing capabilities. This is where
the Fed can play a role in influencing expectations and it is critical
(this is particularly true for borrowers who are up for variable-terms
Look, we know that: (i) Bernanke is a
disciple of Milton Friedman, and (ii) one of Friedman's classic pieces
of economic research pertained to the 'permanent income hypothesis',
which postulated that it is changes that are deemed to be permanent, not
temporary, that induce a permanent change in economic behavior. This is
why the "permanent" Bush income tax cuts in 2000 worked so much better
than the temporary rebates unveiled in early 2008.
the margin, in order to do even more to solve the ongoing depression in
the housing market, which continues to pose as a dead-weight drag on the
entire economy, it may well behoove the Fed in its next round of
stimulus, whenever that may occur (but it will, just not at 1,330 on the
S&P 500), to signal to the public its intent to take down and hold
down the most critical interest rate of all for the mortgage market — and that is the 10-year note.
think for a minute that this not being discussed — Bernanke talked
about embarking on such a scheme, if necessary, when he was still
governor back in 2002:
long-term interest rates represent averages of current and expected
future short-term rates, plus a term premium, a commitment to keep
short-term rates at zero for some time — if it were credible — would
induce a decline in longer-term rates. A more direct method, which I
personally prefer, would be for the Fed to begin announcing explicit
ceilings for yields on longer-maturity Treasury debt ... Lower rates
over the maturity spectrum of public and private securities should
strengthen aggregate demand in the usual ways and thus help to end
deflation. Of course, if operating in relatively short-dated Treasury
debt proved insufficient, the Fed could also attempt to cap yields of
Treasury securities at still longer maturities ... Historical experience
tends to support the proposition that a sufficiently determined Fed can
peg or cap Treasury bond prices and yields at other than the shortest
maturities. The most striking episode of bond- price pegging occurred
during the years before the Federal Reserve-Treasury Accord of 1951.
Prior to that agreement, which freed the Fed from its responsibility to
fix yields on government debt, the Fed maintained a ceiling of 2-1/2
percent on long-term Treasury bonds for nearly a decade.
Ben Bernanke, Deflation: Making Sure "It" Doesn't Happen Here, speech to the National Economists Club, Washington, D.C., November 21, 2002.
was otherwise known as 'operation twist'. There is certainly nothing
preventing the Fed from targeting the 10-year Treasury-note any more
than the Fed funds rate. But the funds rate is already near zero and as
such there is no incremental move there that can benefit the economy. But
targeting the 10-year note in much the same fashion is probably worth a
try and if there is anything else we know about Ben Bernanke. It is
(i) he will be late, not early. So, by
the time this comes the economy may well be back in recession, which in
balance sheet cycles tend to occur every three years, so mark 2012 down
in your calendar;
(ii) he is willing to be very
aggressive when the time comes — he has certainly proven that. Back in
2007 or 2008 for that matter, who believed that short rates were going
to vanish entirely and that the Fed would be buying assets by early 2009?
it is doubtful that the Fed would ever target the long bond. In fact,
the Fed may even want it to be higher in yield to ease the pressure on
radically underfunded pension funds. While the Fed can either target its
balance sheet, which it has been doing with these QE measures, or
target interest rates, it cannot do both at the same time. So the next 'QE' will not be called 'QE' but rather something else — maybe Operation Twist 2 (072 — you heard it here first).
Fed would buy up all the 10-year notes needed to clear the market at
the target "price" (yield). So depending on supply conditions and demand
from the private sector, the Fed would basically lose control of its
balance sheet, but if in return this policy is the one that blazes the
trail for a turnaround in the housing sector and a durable revival in
the economy, so be it.
If the Fed were to be concerned
about the impact that any further balance sheet expansion could have on
the U.S. dollar, it could always nudge the short end of the Treasury
curve up in support of the greenback (short-term spreads matter more in
the FX market). By doing this, the Fed would also lend some much-needed
support to the troubled money market fund industry (for more on this
front, have a look at Low Rates Put Pressure on U.S. Money Markets Funds
on page 13 of today's FT). So much can be accomplished with such a
policy—the upside potential will be worth it.
politically, the Fed has to wait for the next downturn in economic
activity and reversal in the stock market so that those on Capitol Hill
that are lamenting the Fed's interventionist efforts end up begging for
more. This could come sooner than you think, but likely not until we see
the whites of the economy's eyes — and early signs are showing a
visible sputtering in growth.
One last item to note. If, say,
the 10-year note were to be capped at 2 1/2%, where it was at ahead of
the QE2 program last fall, compared with the current 3%-plus level, the
total return for a 10-year strip would come to over 10% in a 12-month
span. Now put that in your pipe and smoke it!