Forget The Twist, Here Comes Operation Torque: Presenting Morgan Stanley's Complete Moral Hazard Profit Guide

Tyler Durden's picture

While we often pick on Morgan Stanley's Jim Caron (the same guy who year after year after year keeps predicting the yield on the 10 year will soar, and not just soar, but soar for all the wrong reasons, such as bull steepening and what not), has just diametrically changed his tune, by bringing us, drumroll please, Operation Torque. To wit: "Policy makers in both the US and Europe get back to work in September, and this month will be rife with deliberations on stimulus and market support policies. In our view, a duration extension to the Fed's SOMA portfolio is an optimal policy tool to engender easing. This can initially be done through extending the duration of reinvestments from MBS and agency holdings but may ultimately culminate in selling shorter-duration USTs in its SOMA portfolio in exchange for buying longer duration assets (‘Operation Torque’, as we at Morgan Stanley have dubbed it)." Why 2 Years? Because as per the August 9 FOMC statement, we know that there will no rate hike for the next 2 Years, and hence no duration risk. Which means that the Fed can sell an infinite amount of paper into a mid-2013 horizon without worrying about demand destruction. And by doing so it will, as we have been predicting since May, expand the duration of its portfolio, in the process pushing investors into risky assets for the third time in as many years. But there is a twist...

...Or a torque as the case may be...

As we have noted on several occasions, going aggressively after the 10 Year would likely mean an even more pronounced flattening of the 2s10s than we currently have: an outcome which more than anything will impair US banks. As yesterday's MBA mortgage refinancing data showed, even at record low mortgage rates virtually nobody wants to refi. Perhaps a forced refinancing will help courtesy of Obama, but we think not. The point being that net interest margin, or the carry trade as it is better known, will all but disappear, and perversely QE3, call it Twist or Torque, will end up generating even more pain for the critical financial sector, without which there is no chance of a broad market rally.

Furthermore, we are amused that MS is implicitly agreeing with us: Caron says - "We believe that if the Fed implements Operation Torque, it will purchase a significant amount in the 30y sector of the curve as well as at the 8-10y point." And it continues: "If the Fed does purchase on the long end, the belly could easily underperform with yields currently near all-time lows. We recommend taking advantage of this opportunity by positioning for the 7s30s to flatten, or trading 7s30s on asset swap as described below." In other words, a flattener with a 10 year hump, so needed for even some incremental 2s10s steepening... Just as we have been predicting.

However, that's not all. We are confident that when all is said and done, the Fed will realize it needs to drop the 10 Y yield modestly in order to afford some profitability for the banks, resulting in an emphasis on the Ultra longs (17-30 Year sector).

There is however a glitch: there is nowhere near enough supply in the 17-30 Year space to meet this need for 10s30s flattening even as the 10 itself floats higher. And while 10 is too short, the 30 is too long, does this mean that the Treasury will soon have to consider converting the 20 Year point on the curve from a simple Constant Maturity Series into an actual cash bond to satisfy the suddenly very picky Goldilocks environment ? Unless Geithner wants to take a chance with flooding the market with 30 year paper, for which the only buyer will be the Fed, it may soon have to.

Anyway, back to Morgan Stanley's Operation Torque. Here is how Caron presents the three core scenarios that the Fed will undertake:

The goal of Operation Torque is to remove duration supply from the market, and not simply to push yields lower. With less supply in the market, risk premiums for spread products should decrease, driving easier financial conditions.

 

During QE2, the Fed removed $490bn in 10y equivalents form the market. If we use that as a baseline, we may evaluate Operation Torque under several different scenarios. As the Fed would not expand its balance sheet under an Operation Torque, there is a limited supply of short-duration debt with which to extend, and the market impact is highly dependent on where it is placed. The three scenarios below help us understand targeting purchases on different parts of the curve could impact the market.

 

Scenario 1: Fed sells all debt with less than two years to maturity and allocates proceeds to the 8-10y sector.

 

Scenario 2: Fed sells all debt with less than two years to maturity. Proceeds allocated to the 8-10y sector and 30y sector, targeting a total of $400bn equivalents removed from the market.

 

Scenario 3: Fed sells all debt with less than two years to maturity. Proceeds allocated in same ratio as QE2 purchases.

 

All scenarios assume a time frame through January 2012 and include estimated auctions. We only include USTs in this particular analysis; however, we estimate that mortgage pre-pays could add up to an additional $90bn should the Fed use those funds to extend duration in the SOMA as well.

And once again, we don't like to gloat, but we did "tell you so" - the Fed will target not the 10 year but the 30 year:

By purchasing in the 30y sector in addition to the 8-10y sector (scenario 2), the Fed could achieve a $436bn purchase of 10y equivalents, having sold the same debt out of the SOMA. This is very close to the same level of duration removed from the market during QE2.

 

Finally, we may compare to an operation that has the same allocations as was done in QE2 (scenario 3). This style of operation has the least impact in duration terms at $186bn – less than 45% of the impact of Scenario 2 (Exhibit 5). Additional detail of each scenario can be found in the appendix to this report.

 

We believe that if the Fed implements Operation Torque, it will purchase a significant amount in the 30y sector of the curve as well as at the 8-10y point. In order to position for this Fed action, we recommend the following:

  • Overweight 9-10y & 30y UST sectors
  • UST 7s30s yield curve flattener
  • 7s30s asset swap curve flattener ? UST 7y to underperform and 30y to outperform versus Libor

We look for trades that benefit from duration buying at the 9-10y and 30y points on the curve. In particular, we recommend duration longs to re-allocate into such as 2020 and 2021 original maturity 10s and 2041 bonds as these have a lot of par available to the Fed and are likely candidates for purchase.

Graphically:

Bottom line: Goldman, JP Morgan, Nomura and now Morgan Stanley all assume QE3 is a fait accompli, the only question is what shape it will take.

And for all intents and purposes, what the Fed will achieve, is to get investors to rush out of anything with a sub 10 Year duration, and into the longest point on the curve. And just like last time, the biggest beneficiaries will be not bonds, nor stocks, but commodities, where the marginal purchasing power is far greater, and the result will be yet another round of geopolitical shocks, this time, as we have said so many times before, far closer to the core: both in Europe and the US. As for the effectiveness of such a move on the economy and stocks, we urge readers to look at the following chart.

 

Below is the complete Morgan Stanley moral hazard playbook.

Market Support

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baby_BLYTHE's picture

insolvent TBTFs like Morgan Stanley are begging for more heroin from Uncle Ben.

bankrupt JPM buy silver's picture

Meth.  MS uses Meth.

 

Ben is a virtual drug dealer now.  Good selection.

Pladizow's picture

Been looking at TMV for 2 years and it looks like that's all I'll be doing for another two.

nope-1004's picture

All these banker whores who espouse flipping dollars here to influence dollars there not only ensure the USD train wreck ahead, but lose credibility along the way.

Dollars are being treated like Monopoly money, maybe worse, with these smoke-and-mirror ideas.  All of humanity pinning hopes to this POS administration and banker cabal will end up sinking with them.

Such a sad situation the USG has become, and so sad that money influences policy..... a completely FAILURE of a policy at best.  Total destruction of money is guaranteed.

 

RockyRacoon's picture

My favorite part:

The goal of Operation Torque is to remove duration supply from the market, and not simply to push yields lower. With less supply in the market, risk premiums for spread products should decrease, driving easier financial conditions.

Somebody correct me if I'm wrong, but this is more of what got us here?  QE3, indeed. 

My second favorite part:

And once again, we don't like to gloat, but we did "tell you so" - the Fed will target not the 10 year but the 30 year:

I read that thus:  The guy is a real asshat as ZH has pointed out in the past, but now that he agrees with us perhaps he's not such a big asshat after all, but an asshat just the same.   His asshattedness has decreased just barely enough that we can now give credibility to his opinions.

zhandax's picture

Theory of asshat relativity?

4shzl's picture

TMV = death wish.  Load up on TLT, or better still, just buy the 30s and enjoy the coupons.  I know, I know: ultimately the Fed's Ponzi will implode -- but it may not be in your lifetime.

One sure sign that we're getting close to a top in the Treasury market: when that bow-tied asshole who recently boasted "I'm short Treasuries as we speak" gets down on his knees on CNBC like the other Jimmy did and 'fesses up good and proper.

http://www.youtube.com/watch?v=Q1OXAi7rNMg

 

DeadFred's picture

"Meth.  MS uses Meth."

Your right. You can tell it's meth by the twitchy changes in their forcasts and their shifty, darting eyes as they lie to you. Definitely meth symptoms.

Ruffcut's picture

Damn, I've Torqued the wife few hundred times.

Captain Morgan, I'm familiar with beong torgued, too. Morgan Stanley has not even asked me for a date, let alone a little torquring between the sheets.

I thought Uncle Ben and uncle Sam, had first grabs. Ohhh, hit my G(government) spot.

Banksters are now calling more of a Operation Joke.

tinsmith's picture

operation torque, huh   anybody know what happens to the wheels on your car if you over torque the lug nuts and they snap.....

OpenEyes's picture

"However, that's not all. We are confident that when all is said and done, the Fed will realize it needs to drop the 10 Y yield modestly in order to afford some profitability for the banks..."

Sounds like they're planning on getting their slice.  Not only are they 'begging for more heroin', they're saying how they'd like to have it delivered.

rocker's picture

One way or another the junkies will get their fix. 

pods's picture

Can we just collapse this thing already?

pods

Ratscam's picture

off topic but I need to share the mail I just received - Comex next?

Margin Increase for Gold and Silver
Due to the recent market volatility in Gold (XAU) and Silver (XAG), Saxo is increasing the margin required for Spot Metal, Spot Metal Options and COMEX Gold Futures positions from Friday 9th September 2011 at 10:00am (CET):

- Metals (Spot, Forwards and Options)
The margins required for XAU and XAG positions will increase from 4% to 6%

- Futures Contract

Both the Initial and Maintenance margins for COMEX GOLD 100oz (GC) will increase to USD 10,950

buzzsaw99's picture

will end up generating even more pain for the critical financial sector, without which there is no chance of a broad market rally...

 

The tapeworm is critical to the functioning of the digestive system.

ThirdCoastSurfer's picture

Too much torque and you strip the gears.

rickA's picture

and ughh. just as ZH posts this operation, my TBT fills

LikeClockwork's picture

Viewing this from outside America, this is all dizzyingly bizarre and tragi-comedy.

AnarchoCapitalist's picture

A beneficiary of the Fed's actions should also be Jeffrey Gundlach's DoubleLine Total Return Fund (DLTNX). This fund holds mostly MBS and 30s. Outside of holding gold and silver, I would suggest taking a look at this fund.

vast-dom's picture

Scary unsustainable shit!

 

Looks bullish as NASDAQ hovers in green at 0.001% with ONLY bad news and anemic volume to levitate it!

 

FUCK YOU QE3 

JW n FL's picture

 

 

FUCK YOU QE3

_____________________________________________________

vast-dom ,

Hey! Hey!!

Wall Street only has Trillions sitting on the sidelines doing nothing..

Think of how much more helpful having yet Trillions more doing even more Nothing would be to those suffering on Main Street!!

Dont be so short sighted!

vast-dom's picture

JW you are correct my myopia is not allowing me to appreciate Main St.'s upside to QE3! 

 

Thanks JW I can now see.  MORE QE3 BIYATCHEZ LET'S GET THE DOW TO 2600 already and save the populace!

 

Main St. don't need funduhmentals!

 

 

JW n FL's picture

http://www.ustream.tv/federalreserve

 

Federal Reserve

189,079 Live Views 686 In Crowd The Housing Market Going Forward: Lessons Learned from the Recent Crisis is a policy forum to be held September 1, 2011. Participants of the forum will examine the contributing factors to the severe downturn of the housing and mortgage markets, reexamine the role of homeownership and rental options, and discuss policy recommendations going forward. The event will be held at the Federal Reserve Board's Martin Building in Washington, D.C., and is organized by the Board's Division of Consumer and Community Affairs.

http://www.federalreserve.gov/newsevents/housingconf2011.htm

Live Captioning of the event is available here:
http://www.streamtext.net/player?event=FRB

 

 

JW n FL's picture

 

 

New item in your series of interest:

IMF Research Bulletin -- September 2011:

The Q&A in this issue features seven questions about economic recovery after "WARS" or other "open conflict"

(by Antonio C. David, Fabiano Rodrigues Bastos, and Marshall Mills).

The research summaries are "Revisiting Capital Controls"

(by Marcos Chamon)

and "Capital Flows and Financial Stability: Monetary Policy and Macroprudential Responses"

(by D. Filiz Unsal).

The issue also provides details on visiting scholars at the IMF (mainly from September through December 2011), as well as recently published IMF Working Papers and Staff Discussion Notes.

http://www.imf.org/External/Pubs/FT/irb/2011/03/index.pdf

 

Greater Fool's picture

Getting to be about time for Treasury to introduce perpetuals....

Mister Ponzi's picture

Or even better: zero bond perpetuals...

Highrev's picture

 

 

The point being that net interest margin, or the carry trade as it is better known, will all but disappear . . .

Oh my! You mean the banks might have to start making real loans to real businesses in order to make money. God forbid!

 

 

LawsofPhysics's picture

Was thinking that too, not a bad thing so long as they don't make BAD loans and bundle them into securities AGAIN.  Anyone who has done any decent auto work knows what can happen when you over torque something.

divide_by_zero's picture

As it just so happens Holder and the DOJ are in the process of doing a backdoor CRA to force bad loans;

http://www.investors.com/NewsAndAnalysis/Article/577794/201107081851/DOJ-Begins-Bank-Witch-Hunt.aspx

 

Translational Lift's picture

You're fucking kidding me ...right???!!!

DeadFred's picture

Chill, this is good news. It pushes the reset up by several months.

RockyRacoon's picture
Holder Launches Witch Hunt Against Biased Banks

So, the banks are biased but the title of the article (Witch Hunt?) is not?  Ist there anything out there that is not slanted, and blatantly so?   This is NOT a comment on the veracity of the article, rather a fervent wish that there could be some objective reporting.   Fox, CNBC, MSNBC, NYT, etc., etc., ad infinitum.   Please!  Show me one unbiased, objective place to find facts -- and let me draw my own conclusions.   That includes ZH.

Just go ahead and junk the crap outta my comment so I can then transition into the stage of questioning my own motives.

pods's picture

Yep, it was a steel bolt into an aluminum transfer case. At below torque specs.

pods

sasebo's picture

With more paper money printed out of thin air?

Species8472's picture

Maybe, I know this will be hard to believe, but maybe the Fed will act to benefit the federal Government and not the banks, after all they can see what will happen.

The Gov needs to lock in low rates so it doesn't get  crushed when they rise, so the Fed drains long bonds and the treasury sells into this. The Treasury gets the low rates, or at least rates that don't rise too much.

 

LawsofPhysics's picture

Always good to be positive, but what has the fed's record of performance been again?

props2009's picture

Chart: Swelling debt is really the problem world over

http://capital3x.com/?p=591

RockyRacoon's picture

If the problem persists for more than 6 hours consult your financial planner.   Financial priapism.

vote_libertarian_party's picture

When everybody says 'x' will happen assume the opposite.

wombats's picture

Isn't this just QE3 dressed in drag?

RobotTrader's picture

 

 

Bears are running out of time to slam this pig.

As long as the 5-year repeatedly crashes to 0.90% on the news of any type of "convulsion" in Europe or elsewhere, people are going to be horsewhipped out of bonds and into stocks where a 5% move in one day can equal 5 years worth of interest.

Look at Bank of NY, up 2.5% in just a few hours after the CEO quits.

Johnny Lawrence's picture

Oh yeah?  How did that work out in Japan?

dasein211's picture

No it's just anticipation of the next fomc meeting. If NFP
Comes in better than expected tomorrow you might get a little rugburn. I don't think equities will get quite the adrenaline rush but commodities sure will. However i don't have any inside info and I can't see where they're secretly pumping money. The euro is the wild card and should something break before then all bets are off. Best to play with just a little cash right now. Keep the rest for when the fog clears.

tradewithdave's picture

Why 2 years? 

Let me think... Hmmm?  Okay, I got it.

In two years, the Fed's charter expires and the reset button can be flipped.  Isn't the gold carried on the books at something like $42?  Once we fully release the Eurasian Huskies to pull the gold laden dog sled up to the $5,000, $7,500, $10,000, FOFOA... summit, we'll be ready to flip the $42 deflationary switch and take our $8 write up to the $50 one ounce gold buffalo coin.

Then all the MBS can be paid back in a currency that allows the new and improved IMF to book the receipts as gold (didn't you hear?... they rolled-up the TBTF).  Just picture a synthetic-fiat-to-gold CDO in reverse. It should be in the fine print of next week's White House ReFi plan for your mortgage.  Remember, you own America, so you own your share of the gold... unless you sign that is.  

What does the national debt look like when it's written down by 99% ($50/$5000) and the Chinese get an equity stake in the new Pan-Eumerican soveriegn in a box (toll roads, expanded ports and the drink stand at Mount Rushmore included).

Dave Harrison

www.tradewithdave.com  

Elooie's picture

This just makes me think the Treasury is going to refinance all its maturities at a longer duration.  Feds been backstopping all of their auctions.