San Fran Fed Defends QE2 By Comparing It To Gold Scramble Prevention Contraption "Operation Twist"
Recently there has been lots of goalseeked speculation by sellside research about what the impact of QE2 will be. Considering that the biggest force in bond buying (PIMCO) disagreed with virtually everyone else, it is safe to say that nobody has any idea what will happen on July 1 (of course unless the Fed also actually stop its off-balance sheet curve vol selling, in which case the imminent collapse in the bond market is guaranteed). Naturally, after the private sector has come out defending its respective books, here come the Admirals of the Obvious from the San Fran Fed to voice in on just how good and wise QE2 was especially when compared to such a "monster" as 1961's $8.8 billion Operation Twist. According to the Fed, Operation Twist, which was truly a curve "twisting" operation instead of an outright debt monetization and deficit funding operation, succeeded in reducing rates by 0.15%. It is this delusion that fostered QE2, which is merely a continuation of QE1 and a contributor to the Fed's soon to be $2.9 trillion balance sheet, as the Fed was obviously trying to recreate history. Little did it realize that Twist was not about the implosion of a shadow banking bubble but all about removing rate arbitrage opportunities. Curiously enough, it was the rush of gold from the US To Europe, to express this arbitrage, that forced the US to engage in Operation Twist. Only later was the gold backing of the dollar completely removed thereby eliminating this arb opportunity. Of course, it is now deja vu all over again: the Fed has to do all it can to prevent the transfer of fiat into gold, albeit at non-fixed rates, or as some have called it, a non-central bank instituted gold standard. Yet oddly enough, despite all time record nominal prices, the demand for gold is only increasing, a result that the Fed had not anticipated at all and is forced to scramble to reverse. And now that QE2 has been a complete failure, the only option is to back track on everything and admit the Fed has failed, or pursue more QE, sending gold offerless. Your call Ben.
From The San Fran Fed:
Operation Twist and the Effect of Large-Scale Asset Purchases
The Federal Reserve's current large-scale asset purchase program,
dubbed "QE2," has a precedent in a 1961 initiative by the Kennedy
Administration and the Federal Reserve known as "Operation Twist." An
analysis finds that four of six potentially market-moving Operation
Twist announcements had statistically significant effects and that the
program cumulatively caused a significant but moderate 0.15 percentage
point reduction in longer-term Treasury yields. These results can be
used to estimate QE2's effects.
John F. Kennedy was elected president in November 1960 and
inaugurated on January 20, 1961. The U.S. economy had been in recession
for several months, so the incoming Administration and the Federal
Reserve wanted to lower interest rates to stimulate the weak economy.
However, Europe was not in a recession at the time and European
interest rates were higher than those in the United States. Under the
Bretton Woods fixed exchange rate system then in effect, this interest
rate differential led cross-currency arbitrageurs to convert U.S.
dollars to gold and invest the proceeds in higher-yielding European
assets. The result was an outflow of gold from the United States to
Europe amounting to several billion dollars per year, a very large
quantity that was a source of extreme concern to the Administration and
the Federal Reserve.
The Kennedy Administration’s proposed solution to this dilemma was to
try to lower longer-term interest rates while keeping short-term
interest rates unchanged—an initiative now known as “Operation Twist” in
homage to the dance craze then sweeping the nation. The idea was that
business investment and housing demand were primarily determined by
longer-term interest rates, while cross-currency arbitrage was
primarily determined by short-term interest rate differentials across
countries. Policymakers reasoned that, if longer-term interest rates
could be lowered without affecting short-term yields, the weak U.S.
economy could be stimulated without worsening the outflow of gold.
Similarities between Operation Twist and QE2
In many respects, Operation Twist was similar to the Federal Reserve’s
recently announced program of Treasury purchases, dubbed “QE2” by the
financial press. First, both programs aimed to lower longer-term
interest rates without lowering short-term rates. In the case of
Operation Twist, the program sought to prevent further gold outflows.
In the case of QE2, lowering short-term rates was not an option because
the federal funds rate had already been reduced to its lower bound of
essentially zero. Second, both programs involved purchasing large
quantities of longer-term Treasury securities. And third, both programs
financed those purchases by selling or issuing short-term government
liabilities. During Operation Twist, the Fed sold off some of its
holdings of short-term Treasury bills. During QE2, it issued bank
reserves, which are nearly identical to Treasury bills in that both are
short-term liabilities of government agencies—the Federal Reserve in
the case of bank reserves and the Treasury in the case of Treasury
Comparison between Operation Twist and QE2
Operation Twist was much smaller than QE2 in nominal terms.
Nonetheless, as Table 1 shows, the programs are comparable when measured
relative to GDP or the Treasury market. First, although Operation
Twist was about half as large as QE2 relative to GDP, it was similar
enough in magnitude to be informative. Second, if changes in the supply
of long-term Treasuries have any effect on long-term Treasury yields,
then the initial quantity of long-term Treasury securities in the
market should be a better benchmark for the size of each program. By
this metric, Operation Twist was closer in size to QE2. Third, to the
extent that debt issued or guaranteed by U.S. government-sponsored
agencies such as Fannie Mae or Freddie Mac are close substitutes for
Treasuries, then the relevant market arguably includes all of these
Treasury-guaranteed classes of securities. Relative to this market,
Operation Twist was even bigger than QE2.
Estimating the effects of Operation Twist
We estimate the effects of Operation Twist using a high-frequency
event-study methodology measuring the one- or two-day response of
Treasury yields to major unanticipated announcements regarding Operation
Twist. The rationale for this approach is that forward-looking
financial markets should quickly incorporate all information from a
public announcement shortly after the announcement is made. Moreover,
it is intuitively reasonable that financial markets would not leave
large profitable trading opportunities unexploited for more than a few
hours, let alone one or two days. Jones et al. (1998) and Fleming and
Remolona (1999) study the response of Treasury yields to major
macroeconomic announcements and find that the yields quickly incorporate
information from the announcements with no evidence of over- or
under-reaction on the announcement date.
We identified major Operation Twist announcements by searching through
the ProQuest Historical Newspapers database for articles in The Wall Street Journal in
1961 and 1962 that mentioned the Federal Reserve or the Treasury. A
quick scan of the few hundred articles unearthed this way found several
dozen related to Operation Twist. Among these, we identified six 1961
announcements that represented major new Operation Twist developments
rather than just summaries or rehashing of the program:
- On February 2, President Kennedy announced the program.
- After markets closed that same day, the Treasury announced an
auction of $6.9 billion of new debt, a large amount, at only the
18-month maturity instead of longer terms.
- On February 9, a Federal Reserve statistical release
showed the Fed had made a rare purchase of longer-term Treasury
securities, demonstrating some support for Operation Twist.
- On February 20, the Federal Reserve issued an extremely
rare public statement explicitly endorsing Operation Twist and
announcing a new policy of buying Treasury securities with maturities of
five years or longer.
- On March 15, the Treasury backtracked to some extent in
its support for Operation Twist by announcing a surprise refunding
using five- and six-year notes, longer maturities than expected.
- On April 6, another Federal Reserve statistical release
showed a sharp increase in open-market purchases of longer-dated
Treasuries, including for the first time maturities longer than ten
Swanson (2011) provides additional details and discussion of each of these announcements.
Treasury yield responses to Operation Twist announcements (basis points)
We collected Treasury yields from the Government Securities column of The Wall Street Journal
for the market close before and after each of these announcements and
used the change in yields to measure each announcement’s effect,
summarized in Table 2. The Federal Reserve’s endorsement of Operation
Twist on February 20 produced the most dramatic effects. Treasury
yields with five or more years to maturity fell 0.06 to 0.09 percentage
point (6 to 9 basis points), a highly statistically significant move.
Moreover, the three-month and one-year Treasury yields simultaneously
increased by 0.11 and 0.06 percentage point (11 and 6 basis points),
creating a clear yield curve “twist.” President Kennedy’s introduction
of Operation Twist on February 2 also led to a large one-day decline in
long-term yields of 0.03 to 0.04 percentage point (3 to 4 basis
points). And the Treasury Department’s policy reversal on March 15 led
to an increase in longer-term yields, particularly at the five-year
maturity for which the Treasury announced that new supply would be
Cumulative response of yield curve to Operation Twist
Source: Data from Swanson (2011).
Note: Black nodes are statistically significant movements.
We use these daily responses to estimate the overall effect of
Operation Twist in two ways. First, we consider the cumulative effect of
the first four announcements, which occurred within a narrow
three-week period. Each of these announcements represented an increase
in the Treasury Department’s or Federal Reserve’s commitment to
Operation Twist. One can interpret this cumulative effect as the initial effect of Operation Twist or what the total effect would have been
with no future policy reversals or mixed signals. Second, we look at
the cumulative effect of all six announcements in our sample. Here the
interpretation is less clear-cut. For example, the fifth announcement,
on March 15, reversed some of the initial effects of the program. There
is also more time between the fourth, fifth, and sixth announcements,
and after the sixth announcement, for more incremental information
about Operation Twist to have come to light, such as the periodic
issuance and refunding announcements by the Treasury and the actual
purchases of Treasury securities by the Federal Reserve. Nevertheless,
summing up the effects of the six announcements gives an estimate of
the total effects of Operation Twist, including the effects of policy
reversals and mixed signals.
Figure 1 plots the cumulative change in the yield curve at all
maturities for the first four and for all six announcements. The
cumulative movement at all maturities is completely consistent with a
yield curve “twist” and is highly statistically significant, but
moderate, amounting to about 0.13 to 0.16 percentage point (13 to 16
basis points) at both the long and short end of the yield curve.
Subsequent research (Swanson 2011) found that the spillovers from
Operation Twist to agency and corporate bond yields were also
statistically significant but smaller, amounting to about 0.13
percentage point (13 basis points) for agency bonds and 0.02 to 0.04
percentage point (2 to 4 basis points) for corporate bonds. Thus, the
effects of Operation Twist appear to diminish as one moves away from
Treasury securities and toward private credit markets.
We find that Operation Twist lowered long-term Treasury yields by about
0.15 percentage point (15 basis points), an amount that was highly
statistically significant, but moderate. This effect is consistent with
the extensive time-series analysis of Operation Twist in Modigliani and
Sutch (1966) and with the lower end of the range of estimates of
Treasury supply effects in the literature (e.g., Gagnon et al. 2010,
D’Amico and King 2011, and Hamilton and Wu 2011). A drop in long-term
interest rates of this magnitude could be important. For example, 0.15
percentage point (15 basis points) is the typical response of the
10-year Treasury yield to an unanticipated 1 percentage point (100
basis point) cut in the federal funds rate target (Gurkaynak et al.,
Finally, it should be noted that the QE1 program in fall 2008 and
spring 2009 differed from Operation Twist and QE2 in several important
respects. QE1 was much larger, it purchased primarily mortgage-backed
securities, and it took place at a time when financial markets were
functioning poorly and were much less liquid. Thus, the financial
market effects of QE1 may have been larger than the effects of Treasury
purchases in the more normal environments in which Operation Twist and
QE2 were conducted.
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