FOMC: Operation twist

Details

As widely expected, the FOMC has announced an increase in the maturity of its holdings of Treasury securities. It will actively sell USD400bln of Treasury securities with maturities below 3 years and reinvest the proceeds in maturities of 6 to 30 years. The Maturity Extension Program will be conducted through the end of June 2012.

The USD 400bln of purchases will be distributed 32% in 6-8Y, 32% in 8-10Y, 4% in 10-20Y, 29% in 20-30Y and 3% in 6-30Y TIPS. The relatively significant amount of purchases in the long end of the curve was a bit of a surprise for the market. 30Y bond yields declined by 18bp on the move, with the 10-30Y flattening by 13bp.

Further, the FOMC announced a change in the reinvest policy for MBS and agency bonds. It will no longer reinvest principal payments in Treasuries, but recycle the proceeds into Agencies instead. While the move seems a bit inferior to the ‘twist operation’, it might be a very important hint. This could be a signal that the Fed is leaving the door open for purchasing Agency bonds if further quantitative easing becomes relevant. Indeed, this makes sense as the Maturity Extension Program is reducing the capacity for further long-term purchases on the Treasury curve.

The interest on excess reserves was left unchanged at 0.25%. The FOMC apparently judged that the cost would be higher than the benefits.

Regarding the description of the economic outlook, the statement got nother dovish tweak. The committee now sees “significant downside risks” to the outlook and refers to “strains in global financial markets”. The Fed repeated that it expects to hold the federal funds rate exceptionally low until at least mid-2013.

As in August, three members dissented on the statement, which indicates an unusually large degree of split with the FOMC. This will probably implies a higher bar for further quantitative easing.

Assessment and outlook

Given that the Maturity Extension Program will not be fully implemented before June 2012, the Fed has now bought itself some time. The Fed will view today’s decision as if monetary policy is set to be eased continuously over the coming nine months.

However, this does not rule out an increased pace of easing, which will be on the agenda if the economy does not begin to show signs of accelerating growth. If necessary, the easing next move will probably be further quantitative easing. Interestingly, the committee seems to open the door for further purchases of Agency bonds in that case.

The move has left 30Y Treasury yields at 3%. We believe that the full impact of the Maturity Extension Program is now almost fully priced into the market. Unless economic data or financial market conditions deteriorate, we do not expect long bond yields to move much lower. Further, we do not think that the Fed will be able to cap long bond yields at current levels if economic data begins to pick up. At least, his was the experience from QEII.

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