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Morgan Stanley Does The (Operation) Twist, Extolls The Virtues Of QE3

Tyler Durden's picture


It was over two months ago that Zero Hedge first described why we though QE3 would ultimately appear in the form a reincarnation of Operation Twist first utilized by the Fed in the 1960s to prevent the gold exodus from the US into Europe (read more here and here), also known as Operation Twist 2. In essence what the Fed would do would be a curve patterning exercise in which the Fed would lower long-term rates by changing the average maturity of Fed holdings, in the process removing substantial duration from the markets, once again pushing investors into far more risky assets such as stocks (but certainly not gold: the CME will see to that). Today, Morgan Stanley's Jim Caron (who has yet to be right about one thing in his prior 3 year forecasts so take this with a grain of salt) explains why Morgan Stanley is a big supporter (read lobbying heavily on behalf of) of Operation Twist 2. Quote Caron: "As outlined in the recent congressional testimony, the Fed could consider several ways to ease financial conditions further. One of the options mentioned by Fed Chairman Bernanke was to provide explicit language to keep the fed funds rate and the Fed’s balance sheet unchanged for an extended period. Another approach would be to keep the balance sheet unchanged but increase the average maturity of its holdings. If this path is chosen, we believe that a significant amount of duration could be removed from the markets – to the effect of $90-150bn 10y equivalents which could lower 10y yields by 20-35bps. Let us explain." Explain away Jim.

A modified ‘operation twist’. In the past the Fed has employed operation twist (in the 1960s) with the goal of raising short-term rates in order to support the dollar while keeping long end rates lower to support the economy. Today, we think the Fed may use a modified version of operation twist with the goal of lowering rates for the entire term structure with particular focus on longer term rates. They could use methods such as lowering interest on reserves that would have the effect of keeping short term rates lower while also increasing SOMA portfolio duration and keeping long end rates low.


In order to put the $90-$150Bn 10y equivalents size into context, the current SOMA portfolio has a total duration of about $990bn 10y equivalents, and the tradable coupon Treasury market has $3tr 10y equivalents. Using SOMA duration extension, the Fed could effectively take duration out of the market equal to about 15% of the current SOMA portfolio – this is over 30% of the reduction in duration that QE2 achieved.


Evaluating the impact on yields from a SOMA duration extension. We can use a framework borrowed from the mortgage market to evaluate what impact a reduction in duration in the SOMA portfolio would have on 10y yields. As we know, Mortgages are a negatively convex instrument, meaning that, unlike traditional bonds, investors accumulate losses at an increasing rate when interest rates rise, and accumulate gains at a decreasing rate when they fall. When mortgage portfolio managers hedge their holdings with Treasury bonds, they must make up for this difference in bond characteristics by buying additional bonds when rates fall and selling bonds as rates rise. The total market effect is that duration is either added or subtracted from the market, and the total amount is due to not only interest rate factors but also factors specific to the mortgage market.

We can turn this model on its head and instead solve for a yield move relative to a change in duration, as we do in the case of a possible increase in the duration of the SOMA portfolio. The situation is comparable to mortgage hedgers buying in a rally. According to our mortgage model, a market outflow of $90bn 10y equivalents from hedging is currently commensurate with a 20-25bp decrease in the 10y yield. In the more extreme case of an outflow of $150bn 10y equivalents, the implied 10y yield decrease is 30-35bp.


SOMA duration-extension scenarios. The Fed currently holds $2.6T of Treasury, Agency and Mortgage bonds in its SOMA portfolio (Exhibit 1). Of the $1.54Tr in Treasuries, a majority of the holdings are in the belly of the curve (Exhibit 2). In terms of duration, the belly and long-end sectors all have approximately equal amounts at about $200bn of 10y equivalents in each of the 4-6y, 6-8y, 8-15y, and 15-30y sectors. Of the $1.54Tr in SOMA par value, the total portfolio duration is approximately equal to $992bn 10y equivalents.


There are plenty of available short-dated securities that the Fed could use to extend duration in the SOMA. Coupon bonds with 2.5y to maturity and less in the SOMA total about $390bn. Adhering to the current Fed purchase regulations, there is approximately $350bn of par available in the 4-6y and higher sectors.


Although it is highly unlikely that the Fed would purchase all USTs available to it with greater than 4y to maturity, we nevertheless use this scenario as an upper bound on the amount of SOMA extension and thus duration that can come out of the market. We choose two other, more realistic scenarios, with the Fed using $100bn and $200bn of short-term notes to fund longer-dated purchases. In each of these latter two scenarios, we attempt to spread the duration evenly across the back end of the curve in order to match the current SOMA duration profile (Exhibits 3 and 4).


Scenario 1: $100bn of short-duration par extended. In the first and most conservative of our three scenarios, we assume that the Fed sells $100bn of short-end par amount, and extends into longer-duration debt. Specifically, we assume that the Fed takes the total extension from this sector ($191bn is available), and allocates proceeds by 35% into 6-8y, 47% into 8-15y, and 14% into 15-30y.

This extension takes the maximum eligible remaining amount from the 6-8y sector and overweights the 8-15y sector versus the 15-30y to compensate. This operation removes a total of about $90bn in 10y UST duration equivalents from the market.


Scenario 2: $200bn of short-duration par extended. Doubling our scenario 1 extension par amount provides a significantly more aggressive impact on market duration. We assume that the Fed sells all of the 0-1.5y sector and 4% of the 1.5-2.5y sector and reallocates the proceeds 40% into 4-6y, 17% into 6-8y, 30% into 8-15y, and 13% into 15-30y.


Again, all eligible bonds are purchased in the 6-8y sector, and we slightly overweight the 8-15y sector in duration. In this scenario, we do target a lot of bonds in the 4-6y part of the curve, which provides a more even duration profile, but does not maximize extension. Nevertheless, we believe that this more closely represents what the Fed would actually do. Total duration removed from the market is $150bn in 10y equivalents.


Scenario 3: $350bn of short-duration par extended. This scenario is meant to represent the maximum meaningful duration extension that could be accomplished – an upper bound on the SOMA extension. With the current Fed purchase limits, any additional short-duration bonds sold above the $350bn would simply be re-allocated into the 4y and under sectors. $359bn in proceeds are allocated 30% to the 4-6y, 10% to the 6-8y, 30% to the 8-15y, and 30% to the 15-30y sectors. Taking out all the available 30y USTs, this scenario drastically overweights the 30y sector. At $200bn in 10y equivalents, the 15-30y sector duration removed doubles the second-highest sector, the 8-15y.

So there you have it: it's coming. And it's almost here.


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Fri, 08/05/2011 - 14:52 | 1527843 Mike2756
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20-35? That's it?

Fri, 08/05/2011 - 15:01 | 1527876 Hansel
Hansel's picture

Because everyone knows that interest rates are just too high.  10-year is yielding 2.54%.

Fri, 08/05/2011 - 15:09 | 1527895 hedgeless_horseman
hedgeless_horseman's picture

If you have to go to your back-up gun something has gone terribly wrong.

Fri, 08/05/2011 - 15:39 | 1528006 Buckaroo Banzai
Buckaroo Banzai's picture

Operation Twist! Love the name. Let the fucknuttery begin!

Fri, 08/05/2011 - 15:09 | 1527846 HelluvaEngineer
HelluvaEngineer's picture

There's a typo.  You typed "Virtures of QE3".  I think you meant "Vultures of QE3"

Edit: this pun made more sense before the typo was fixed.  I swear.


Fri, 08/05/2011 - 14:50 | 1527847 Temporalist
Temporalist's picture

I'd like to extoll the virtues of eating glass.

Fri, 08/05/2011 - 15:22 | 1527928 oddjob
oddjob's picture

I'd like to extoll the virtues of Pledge.

Fri, 08/05/2011 - 14:52 | 1527848 JW n FL
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THE FORMER PRESIDENT OF THE WORLD BANK, JAMES WOLFENSOHN Explains how Americas Production / Manufacturing has been and is continuing to be cut into pieces and moved off shore. This is very much worth your time, if you are from the West or planning on living in the West.


America was sold off to the World.

***** “Over the last ten years, China has mounted the biggest challenge to the U.S. manufacturing sector ever seen, threatening producers of steel, chemicals, glass, paper, drugs and any number of other items with prices they cannot match. Not coincidentally, the United States has lost an average of 50,000 manufacturing jobs every month during the same period.” *****


The United States has shipped over 7 Million Manufacturing Jobs to China in the last 11 years.. along with those 7 Million Manufacturing Jobs the Tax Base that those 7 Million Manufacturing Jobs Represent. If you look at a 25% tax bracket for $50,000 dollar average pay.. over 10 years.. works out to $7 Trillion Dollars or Half our National Debt.

Former World Bank President: Big Shift Coming

James Wolfensohn, former president of The World Bank and CEO of Wolfensohn and Co., addressed Stanford Graduate School of Business students with details about his work at the World Bank during its transition years and how the equation between developed and developing countries is changing. Wolfensohn claimed that in the next 40 years, a global power shift will see today's leading economic countries drop from having 80% of the world's income to 35%.

Related Article:

Global Speaker Series:

Recorded: January 11, 2010

Fri, 08/05/2011 - 14:57 | 1527863 DeltaDawn
DeltaDawn's picture

Get your "Don't blame me, I voted for Perot!" bumper sticker while they last.

Fri, 08/05/2011 - 15:01 | 1527884 Waffen
Waffen's picture

I loved perot as a teenager..  He was our only chance.

Fri, 08/05/2011 - 15:58 | 1528076 Byte Me
Byte Me's picture

Perot was never, ever, a teenager..

Fri, 08/05/2011 - 14:57 | 1527865 bigdumbnugly
bigdumbnugly's picture

i didn't see any mention of smoke and mirrors in there but is that just implied?

Fri, 08/05/2011 - 14:58 | 1527869 Elooie
Elooie's picture

So they want short term rates to increase and long term rates to decrease? Or did I read that wrong?

Fri, 08/05/2011 - 15:01 | 1527875 LawsofPhysics
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Okay, two important question.  1) does anyne believe this shill and 2) what will it mean for the markets?  Institutional "suckers", HFT algos, and the Federal reserve/PD twist are the only things levitating the market right now, in layman's terms, how does this help the longs?  I still think they are suckers.  Great shorts and puts yeasterday and a dead cat bounce today.  I still see one step forward, two steps back, until 1) QE3 in earnest begains or 2) the jobs picture suddenly changes.

Comments please, I want to take a vacation and want to park everything for a bit.  Just looking for a safe parking spot.  Thanks ZH for all the help these last two years.

Fri, 08/05/2011 - 15:02 | 1527879 John Law Lives
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More good news;

The US Postal System posted a $3.1 billion loss in Q3 and warns of default.

QE for everybody!!!

Fri, 08/05/2011 - 15:44 | 1528023 DeltaDawn
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I would rather have a functional postal service than all the surveillance equipment and expensive drills being conducted by Janet, but that is just me.  

Fri, 08/05/2011 - 15:06 | 1527880 DormRoom
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They were trying to flatten the curve to decrease Aggregate Demand (less imports to remedy the account balance deficit) but at the same time increasing Aggregate Demand to get out of the recession.

Didn't they read the Fed report on Operation Twist?  It was shown to be ineffective @ curtailing persistent account balance deficit, and the recession of '64.

Fri, 08/05/2011 - 15:06 | 1527889 SheepDog-One
SheepDog-One's picture

Well TARP, QE1, QE2, QE with a twist, have also all proven to be total failures as well, Im sure that detail wont stop them from more of the same though.

Fri, 08/05/2011 - 15:27 | 1527953 Smiddywesson
Smiddywesson's picture

Bad doggie, TARP and the QEs are working exactly as intended.  They bailed out the banks.  Changed the accounting rules.  Reinflated the equities and commodity markets for the trading desks of the banks.  Bought the banks time to call in loans and cancel your line of credit, and most of all, kicked the can down the road so the banks can slowly buy gold and buy their way out of their predicament when the US dollar does what the USG needs it to do, crash so Uncle Sam can do a chew and screw.  That's a win win situation.  The USG gets off the entitlement and debt hook, and the banks walk away solvent and stuffed with our savings (in the form of real assets like gold).

All in all, I think it's worked out really well, just not for me.

Fri, 08/05/2011 - 15:47 | 1528035 Sam Clemons
Sam Clemons's picture

You said it well.  People that claim Bernanke is a moron need to evaluate the premises upon which they view him.  He is not there to help every day citizens. 

He is there to help the banks, and he's done a pretty good job of it, but I think BAC will be the next sacrificial lamb since they stuffed it full of toxic assets.

I have noticed that the QE effects seem to dwindle faster and faster.  I'd guess that will happen until there are minimal effects and only gold / silver go up.

Fri, 08/05/2011 - 15:12 | 1527907 Mike2756
Mike2756's picture

So they are throwing in the towel on asset prices in favor of a stronger dollar? On the bright side, lower oil will juice demand, maybe. lol

Fri, 08/05/2011 - 15:07 | 1527891 buzzsaw99
buzzsaw99's picture

Dumbest idea evah.

Fri, 08/05/2011 - 15:08 | 1527892 SheepDog-One
SheepDog-One's picture

So its not a money shower to Wall St stocks, this QE 'whatever' will just be a clandestine rate tweeking operation?

Fri, 08/05/2011 - 15:14 | 1527897 Mercury
Mercury's picture

So, can this be accomplished without printing any more $$ - just selling shorter term securities out of the Fed's SOMA and buying farther-out maturities with the procedes?

Fri, 08/05/2011 - 15:07 | 1527900 GiantWang
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Echo Tango Foxtrot, Bitchez!!!!!

Fri, 08/05/2011 - 15:11 | 1527904 Peter K
Peter K's picture

"In the past the Fed has employed operation twist (in the 1960s) with the goal of raising short-term rates in order to support the dollar while keeping long end rates lower to support the economy." 

So much for those manufacturing led recovery jobs we've been hearing so much about. Bernank, going over to the dark side ;)

Fri, 08/05/2011 - 15:15 | 1527912 SheepDog-One
SheepDog-One's picture

I dont buy this for a minute, the entire plan since TARP has been to weaken the dollar and transfer more of our jobs overseas and weaken our economy, now we're to believe theyll reverse course and raise rates in a jobless recession? GS knows theyre lying from the start.

Fri, 08/05/2011 - 15:31 | 1527975 Smiddywesson
Smiddywesson's picture

Exactly.  I also say they will continue to weaken the dollar.  That's the plan, and if it weren't, the central banks OF THE WORLD would not be stacking gold.

They will continue to inflate whatever asset markets the banks are trading, and continue to manipulate those markets in favor of the banks.  Meanwhile they will print and give the money to the banks so they outrun inflation.  We, on the other hand, pay the new and inflated prices.

Fri, 08/05/2011 - 15:16 | 1527918 DarkStarDog
DarkStarDog's picture

Pigmen fix'n to steal the sheeple's fake wealth.

Fri, 08/05/2011 - 15:18 | 1527921 SheepDog-One
SheepDog-One's picture

I like Ron Pauls plan better, to null and void the FED's $1.5 trillion in bonds it has only because theyve printed it all up out of thin air.

Fri, 08/05/2011 - 15:22 | 1527931 Doyle Hargraves
Doyle Hargraves's picture

Cheerleaders for QE3 out in full force right before Jackson Hole-check

Markets wobbly and weak before Jackson Hole-check

European Disaster unfolding-check

BAC takedown imminent-check

Yeah sounds like QE be it stealth or not is already a done deal. The BAC takedown will dictate the meat of how it happens and if any CONgressional/debt brotha support will be required to eat the losses. 

Bullion, Bullets, and Beans Bitchez!-check

Fri, 08/05/2011 - 17:29 | 1528334 prophet
prophet's picture

Free ML.  


Fri, 08/05/2011 - 15:22 | 1527934 johngaltfla
johngaltfla's picture

Morgan Stanley is still in business? I thought Thursday forced them to go WaMu....(jk)

Fri, 08/05/2011 - 15:25 | 1527947 Jonas Parker
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Fri, 08/05/2011 - 15:26 | 1527959 Smartie37
Smartie37's picture

This truly embodies the definition of a PONZI,

as incoming money is used to pay off prior investors....................

..........until we run out of NUBES !!!!!!!

Fri, 08/05/2011 - 15:40 | 1528009 narnia
narnia's picture

You guys are trying to prognosticate how a game of football is going to go down, without recognizing that the game being played is blitzball.

The Fed is going to set a range of interest rate "targets" along the yield curve.  This can be managed by a combination of Treasury issuance management & the Fed's open market activities- which are only limited by the Fed's imagination in our current system.  

Figuring how to accomplish these "targets" within the existing Fed balance sheet is a useless exercise.  They'll do it by any means necessary, even a balance sheet expansion.  They'll only announce the balance sheet expansion if they feel it advantageous to do so (which I don't see).

Fri, 08/05/2011 - 15:59 | 1528072 youngandhealthy
youngandhealthy's picture

+100....thats the way it gonna be

Fri, 08/05/2011 - 16:58 | 1528243 LawsofPhysics
LawsofPhysics's picture

Yep, and gold, silver, and anything physical of practical use or barter, will explode to the moon.  Hell, got fresh water?

Fri, 08/05/2011 - 15:55 | 1528060 Gold Man-Sacks
Gold Man-Sacks's picture

Why is Operation Twist 2 any worse than what the Fed currently does with FOMO?  Why is it worse to target longer-term interest rates?

Fri, 08/05/2011 - 15:59 | 1528077 youngandhealthy
youngandhealthy's picture

You R is not...and thats what they have been doing....why just use Bills? USD is a reserve currency, right? So why not use it, right?

Fri, 08/05/2011 - 16:20 | 1528143 ElvisDog
ElvisDog's picture

Operation Twist2 = QE3 = rearranging the deck chairs on the Titanic. Can't wait to hear Obama explain why gasoline is $6.00 per gallon heading into the Nov 2012 elections.

Fri, 08/05/2011 - 17:19 | 1528299 Highrev
Highrev's picture

Well I guess we know who's trapped long.

(Good thing for the chumps that they've got a good bounce coming after Monday's initial sell down.)

Fri, 08/05/2011 - 19:32 | 1528517 Ye Ye
Ye Ye's picture

Ugh.  They do this, the 10y yield will go up by 50bps.

They need to target price, not quantity, or else go home.

Wed, 09/14/2011 - 04:52 | 1667429 chinawholesaler
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