Why Goldman Is Surprised By The Market's Reaction To The Twist, And What's Next For The Fed?

Tyler Durden's picture

After spending the last few weeks 'helping' the Fed with its agenda, Goldman Sachs' Andrew Tilton seems a little disappointed by the market's reaction - reasoning that the FX and equity-investing plebeians will take longer to  comprehend the less familiar 'twist' operation that has already been wholly discounted into the TSY curve. While he did not get all he wanted from this meeting (even though the 'twist' was larger than expected), Hilton wastes no time in looking to the future and the  chance of further economic weakness leading to more dramatic Fed actions.

From Goldman Sachs US Daily : Fed Does the Twist, Though Not Everyone Dances

  • This afternoon the Federal Open Market Committee (FOMC) announced plans to sell short-term securities on its balance sheet and buy longer-term securities, "doing the twist" in market parlance. We estimate that implementation--to be completed by mid-2012--will increase the total duration of securities on the Fed's balance sheet by nearly $400 billion ten-year equivalents. The Fed also indicated it will shift the reinvestment of maturing and prepaid agency debt and agency mortgage backed securities from Treasuries into agency MBS, providing incrementally more support for the housing sector. Overall, the easing action was more aggressive than our expectations or the market's.


  • Still, not everyone danced along. Several Congressional Republican leaders wrote a letter to Chairman Bernanke at the outset of the meeting asking the FOMC to refrain from more stimulus. Three members of the FOMC--regional Fed presidents Fisher, Plosser, and Kocherlakota--dissented from the decision. And the market reaction was mixed, with the yield curve flattening as anticipated but equity prices down sharply, the dollar stronger, and overall financial conditions tighter on the day.


The justification for this action was, of course, the weak economic outlook. The statement emphasized the weak state of the economy, suggesting "continuing weakness in overall labor market conditions" and "only a modest pace" of growth in consumer spending. At the same time, inflation remained a secondary concern, with the statement noting the moderation in (headline) inflation in recent months and reiterating the expectation that inflation will "settle...at levels at or below those consistent with the Committee's dual mandate". While the FOMC still forecasts some improvement in the pace of growth over the coming year,there are significant downside risks to the economic outlook, including strains in global financial markets". The statement retained an easing bias, noting again that the FOMC "is prepared to employ its tools" to "promote a stronger economic recovery in a context of price stability".


Although the broad thrust of the statement and action were consistent with our expectations, the overall easing move was larger than we anticipated, for several reasons:


A bigger "twist" than most had expected. In previous commentary we had indicated an expectation that the Fed would sell perhaps $300bn in shorter-term securities maturing within 2-3 years (see yesterday's US Daily, "FOMC Preview"). The $400bn announcement was bigger than our expectations, and probably the market's as well.


A slightly higher share of purchases at the long end. Detail available on the New York Fed website (www.newyorkfed.org/markets/opolicy/operating_policy_110921.html) indicates that 29% of the purchases are expected to be nominal Treasuries of 20-30 years' maturity, probably a bit more than markets had been expecting. Together with the bigger nominal size of the twist, our calculations suggest the Fed will add nearly $400bn in ten-year equivalents to its balance sheet; our conversations with clients implied a market expectation consistent with our own view, in the range of $300-$350bn.


Reinvestment in MBS. The FOMC indicated that as agency debt and agency mortgage-backed securities mature, it will now reinvest these proceeds in agency MBS rather than Treasury debt. This implies flat rather than declining holdings of agency securities, and therefore incrementally more support for the housing market than previously. (Recall that some FOMC participants had objected to--and presumably continue to object to--purchase of agency rather than Treasury securities on the grounds that these interfered with credit allocation.)


The Fed made no change to its 25bp rate on excess reserve holdings; we had seen a slightly-better-than-even chance that this would be cut to around 10bp, in part as a signaling device and in part to help tamp down any effect of short-term Treasury sales on the front end of the yield curve. In the end, the FOMC apparently decided that the costs we identified--potential interference with the normal functioning of the federal funds market, unwanted interactions with deposit insurance fees, and effects on money market mutual funds--outweighed the modest benefits. (For more details, see “Revisiting the Rate on Reserves", US Daily, September 13, 2011.) The lack of a change in IOER also could be viewed as a sign that the FOMC is confident its conditional rate commitment is sufficiently credible to keep short-term rates low without other actions.


About a month ago, we explored the potential impact of a "twist" on interest rates and the broader economy (see "For More Easing, Will the Fed Go Big or Go Long?, US Daily, August 15). In our view, Fed asset purchases operate by reducing the supply of duration in the bond market, increasing the equilibrium price (and reducing the equilibrium yield) for medium- and longer-term securities. Thus, to provide stimulus via its balance sheet, the Fed can either "go big"--expand the balance sheet by purchasing more securities--or "go long"--increase the average duration of the securities it holds.


The tradeoff between these two options is illustrated in the chart below, reproduced from the August 15 US Daily. It shows the average duration of the Fed’s balance sheet on the horizontal axis and the total size on the vertical axis. Prior to the financial crisis the Fed's balance sheet had a total size of approximately $900bn and an average duration of between two and three years. Two rounds of asset purchases expanded the balance sheet to its current size of $2.6trn and also increased its average duration to about 4 1/2 years. Our past work on this topic suggests that in total, and holding growth and inflation expectations constant, this balance sheet expansion lowered ten-year Treasury yields by about 50 basis points. If the Fed wanted to lower ten-year yields another 25bp, it could choose a variety of options; two possibilities would be expanding the balance sheet while holding its average duration constant ("going big", point A) or holding the balance sheet constant while increasing its average duration ("going long", point B).


When fully implemented, the "twist" announced today will take the Fed almost all the way to point B. The Fed expects the average duration of the Treasury portfolio to increase to around 100 months, which would imply an average duration for the entire balance sheet of nearly six years (if the duration of the agency securities in the portfolio did not change on average). Given our previous work, this implies an impact on ten-year Treasury yields comparable to QE2, in the range of 15-30bp.


Although the Fed took a bold step with the twist, not everyone danced along. News media reported earlier today that several senior Congressional Republicans had written a letter to Chairman Bernanke at the outset of the meeting asking the FOMC to refrain from more stimulus. And once again, three FOMC members--Dallas Fed President Fisher, Minneapolis Fed President Kocherlakota, and Philadelphia Fed President Plosser--dissented, with the statement noting only that they "did not support additional policy accommodation at this time".

The market reaction was also mixed, as Exhibit 2 indicates. The yield curve did indeed twist--with the difference between ten-year and two-year Treasury yields flattening 11bp to 166bp. But other asset prices responded in ways atypical for monetary easing: the dollar rallied, equities slumped, and commodity prices fell. On net, our GS Financial Conditions Index actually tightened on the day, certainly not the reaction Fed officials would have been hoping for. Given the market most focused on the implications of the "twist" did react in the way we expected, we are surprised at the behavior of other markets; one possibility is that the unconventional move will take more time to digest in markets less familiar with its likely method of action. Indeed, we found in prior work that the equity and foreign exchange markets seemed to lag behind the fixed income market in pricing in asset purchases (see "QE2: How Much Has Been Priced In?", US Daily, October 7, 2010).




What's next for the Fed? Probably a continued easing bias, but without further actions in the near term unless the economy weakens further. After all, the Fed has just announced major easing steps focusing on the front end of the yield curve (its August 9 conditional commitment to keep the funds rate exceptionally low through mid-2013) and the back end (today's "twist"). The Fed plans to implement the "twist" through mid-2012, so it will likely take substantial further deterioration in the outlook to change course before then. While this clearly remains a risk, it is neither the Fed's base case nor ours.

If the FOMC chooses to do more, the most likely easing options would seem to be stronger versions of those just announced. In the case of the front end, the Fed could extend its rate commitment or tie it (per the proposal by Chicago Fed President Evans) to specific targets for unemployment and inflation. To ease longer-term rates further, the Fed would likely return to outright balance sheet expansion.


And for good measure here is the continuing saga of pricing in the TSY curve 'Twist' as 30Y is now -27bps from Tuesday's close!!

Chart: Bloomberg


So it seems that we are all but fully discounting the impact on TSY markets and the slower growth outlook and non-expansionary balance sheet effects seem unlikely to cause significant portfolio rebalancing effects given no LSAP this time - or maybe as Andrew notes, we are slow on the uptake.

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Spirit Of Truth's picture

Screw Lloyd Blankfein and GS.  God does His own "work" and it's not subject to the money-sucking whims of the giant vampire squid on Wall Street.  


Hedgetard55's picture
Isa 43:13 Indeed before the day [was], I [am] He; And [there is] no one who can deliver out of My hand; I work, and who will reverse it?"
Silver Kiwi's picture

a couple of questions;


If  the Fed is selling short term treasuries to buy longer term treasuries; who's the big buyer for all the short term paper in a couple of months when the world suddenly wakes up & realises that it's worthless and


I'm assuming that all the 30 year treasuries that Pimco snaped up over the last few weeks will now return them a very nice profit as the Fed buys them. Any idea what sort of margin we're talking for a couple of weeks work??

A Proud Canadian's picture

I have the same questions.  Why wouldn't the fact that the Fed is going to sell all those short term bonds drive the price down (and hence the ST interest rates up)?  Wouldn't this selling the short end and buying the long end tend to invert the curve?

Yen Cross's picture

 Goldmans isn't surprised. They are flabberghasted. Why is George Soros on my Asian feed (CNBS) with [Maria} ba-ba-wa-wa?

   Tyler soros just transferred his wealth to his so" called family ( investment scheme) to avoid the CFTC(United States) broker aggreements! He liquidated 1/20th of his holdings. Can we do a follow up on this ass clown, that want's to tax the " Wealthy"?  


What is wealthy? 250k is chump change!    P.s. Nice divergence on that bottom chart. Like quadrapeds walking up a wall.


     In (O) Gravity.

Maniac Researcher's picture

Most of the people on this planet will never see 250 grand in their whole lives. You are utilizing a delusion to support your ideology.

myne's picture

You're technically wrong, and most likely will be nominally wrong.

Technically, most people will see 250k easily by the time they're 30. They just have to spend it all to live.

But your intent is clear, that they're not likely to be able to invest 250k in their entire lives. So on that part you're right - in real terms.

Nominally, on a long enough timeline, the minimum wage will be 250k one day. I suspect that this time line in some countries is going to be rather compressed.

GubbermintWorker's picture

No, technically you're wrong. The latest figures I could find are from 2005 and I'm too lazy to find any newer ones but , as of 2005, people living in rich countries had an average income of about $35,000. The high incomes in these countries make the world average income four times larger than the world median income, which was $1,700 that year.

I seriously doubt that people who make that much, or less, will live to be over 150 years of age.



ReactionToClosedMinds's picture

them pitchforks are acoming ....

... just read how FDR 'New Dealers' did a "Star Chamber" on former Treasury Sec'y Mellon in mid-1930s.  I went to law school and have worked corporate/commercial/taxes  before being pure biz person entire career.

Never ever heard about any of this in law school or outside ..not one law review article on this travesty.

to the uninitiated... to say "Star Chamber' in the law essentially means they made up all the processes and arguments of law to persecute him for essentially purely political reasons.  I am not overstating this ... Mellon essentially faced  a Putin or bolshevik 'due process' ... this is exactly what it was.  There were no 'facts' to the case ..... but they came after him anyways ... repeatedly for years ..l  they (FDR approved it , Sec'y of Treasury Morgenthau advocated it, Attorney General Homer Cummings enthusiastically sought to find avenues to prosecute all this ....) made up 'new rules' for prosecution 'on the spot'..... becaue they wanted to ....he was the archenemy.  I never knew this happened in the USofA  except under Jim Crow in the Democratic Party old South. 

Rule of Law    Haaaah   ...depending upon the political moment that is ......

why do I waste your time bringing this to your attention?  Becasue if it happened then (and no one ever remembers it for convenient political conscience) and it will happen again ...when it suits the public's or political winds purposes.

here they come ..... will it be you ... or you ..... or your neighbor ..... or relative ....




wattsnotsaid's picture

Now with long terms rates lower,, our retirement income will be even lower .  No wonder we're not spending and not retiring--- keeping the unemployment rate high.

alien-IQ's picture

Well...judging by the futures and FX trading tonight...the market isn't quite done "pricing in" today's news.

/ES down another 5+ points
EUR/USD nearing 1.35
AUD/USD at parity.
DXY just slightly above 78 for the first time since Feb of this year.

and just for shits and giggles...check out the daily chart on USD/MXN (that Mexico vacation just got a lot cheaper in the last six weeks...and especially the last 6 days)

Milton Waddams's picture

In the old days, say circa 2006 - 2007, a flattening yield curve was indicitive of monetary tightening.  I suppose in the modern era this can be perceived as tightening but... but it ought to be beneficial to: fixed income traders, real estate speculators and the dollar. 

ReactionToClosedMinds's picture

exactly ... but methinks the 'waters' are too 'muddy' for anything to work but clearcut paths to 'resolution' ... whatever that may be

mcguire's picture

i still cant believe they are buying MBSs... what a total farce.. 

ItsDanger's picture

Ben's actions today was pathetic.  Does any rational person think that his strategy would change anything?  What a waste.  Negligible impact at best.

Solid Gold Bubble's picture

Operation Pancake, bitchez

Sizzurp's picture

The problem is debt... we have to much of it, and until it is liquidated or re-organized it is going to be a ball and chain around this economy.  We are going nowhere but perpetual recession. There is no escaping the pain, but this action by Bernanke isn't going to address the problem of debt.  All it does is keep the debt bubble alive longer.  This is like dying a death of a thousand cuts, slow and agonizing.  Just get on with it. The answer is default, bankruptcy, monetary re-organization and massive government and entitlement reforms.  Do that and we can start to grow and innovate again.

ReactionToClosedMinds's picture

we & Europe are different from Japan .... but not totally either .

I would revise your comment to say almost all developed economies face what you sugggest

Creditstaldt collapse ...go read up on it ... maybe better projection than Japan

Sizzurp's picture

You mean the Kreditanstalt bank collapse in 1931. That was a Rothschild bank in Austria that went down and spawned contagion in the western world. I am not saying it wouldn't have to be carefully coordinated and planned, but reforms are coming by hook or by crook.  Better to embrace the horror, accept it, and get it over with.  Hopefully, we could avoid war, but with each passing year we get weaker and weaker. Soon we might be unable to provide necessary security to ensure an orderly transformation.  Our enemies might have other plans if we cannot enforce our own.

Bastiat009's picture

It looks like gold is going down and the US$ up after the Fed's twist announcement. Isn't it good? Isn't it what the Fed wanted?

I am not saying I understand the logic. I am not saying I understand why there is a federal reserve. I am not saying that I see how this will put an end to the depression, but the Fed is not helping Wall Street this time, is it?

The question is: who is it helping?

Sizzurp's picture

Deflation is their worst nightmare.  It means government revenues will collapse pushing us deeper in debt.  States and pensions will go belly up, and the debt gets more expensive to pay down.  No they can't have it, they have made a mistake.  Financial repression is the formula they are trying to follow, which is orderly currency devaluation, and growth as a way to reduce debt.  This ain't it. Worse, it means they are losing market confidence so further interventions may not have the desired effect.  This is not the market reaction they wanted. We may be on the verge of a disorderly melt down to the default scenario.

twotraps's picture

very well said, totally agree.  there should be another way to let the pressure off...allow a market mechanism to price it and allow more people to fail and washout their debt.   The problem is that you absolutely cannot use reason, logic, historical precedent or anything to plan for scenarios.   I keep coming back to the fact that the Fed will hang on to control at all cost, even if its a mess.

Mrs Kensington's picture

Yes, I think it is good.  And what seems to be happening is that under enormous pressure from the GOP and the Chinese, Bernanke has finally been brought under control. This will help the people (mortgages) not the banks (QE).  The tone change will be Obama's last gasp message for re-election, all gears into reverse on Wall Street......

By the way, the greed of goldbugs is quite spectacular - after the crazy ramp up this year they are still baying and propagandising for more.  They deserve the fate of Gollum, who, if you recall, fell into a burning chasm of molten lava trying to save, and still holding his "precious" gold ring.

Sathington Willougby's picture


Neither a borrowr nor a lender bee, a goldbug.

DrunkenMonkey's picture

So, in other words, this statement is a call for le bernankrupt to go and intervene further before June 2012 ?

buzzsaw99's picture

...one possibility is that the unconventional move will take more time to digest in markets less familiar with its likely method of action. Indeed, we found in prior work that the equity and foreign exchange markets seemed to lag behind the fixed income market in pricing in asset purchases...


This is weak, even by Goldman standards. The implication is that when equity markets realize what a great thing twist is it will respond favorably? That's the spin? Everyone and their dog (even goldie) understands that the stock market has gotten way ahead of itself and was betting on a huge stimulus. Break out Abby Baby bitchez!

oogs66's picture

maybe goldman should start reading zerohedge

EZYJET PILOT's picture

Mrs Kensington, don't be naive. Nothing Bernanke does is for the people. This will do nothing for mortgages, especially with homes already so overvalued. It does help the bankers because part of the twist is to buy MBS, this is the prelude to something much larger in 2012 when we'll see the real ugly QE3.

spanish inquisition's picture

Call it for what it is, Operation Market Manipulation to Save the Fed.

Now look at the name and go "shit, they have been doing that for years and it hasn't worked for anyone but the Fed, its owners and distribution system (Wall Street). And some good money for its minions in politics and economic buffoons."