Operation Twist Is Operation Desperation

After the dismal jobs report on Friday, the Federal Reserve is frantically searching even for the smallest straws possible to grasp on to justify its existence. Now they are going back to Operation Twist, a financial sleight-of-hand used in the 1960s to “flatten the yield curve.” What it is, the Fed sells short-term Treasury bonds and uses the money to buy long-term Treasury bonds; in other words, the Fed increases the maturity of the government debt it holds on its balance sheet. This is expected to bring the short-term rates up, the long term rates down, and thus the banks would be more inclined to lend money short-term and stimulate the economy.

This may look confusing but it actually is pretty simple: The yields on Treasury bonds have indirect influence on the interest rates on the market. The yields themselves are the difference between the market price of the bond and the face value. If the market price of the bond is $95, and the face value is $100, and the maturity is in a year, your yield is 5%. The lower the market price is, the higher the yield.

The “spread” between short-term and long-term yields is very wide. Why? Because the short-term bonds are priced very high, and the long-term bonds are priced very low. To “flatten the yield curve,” the Fed wants to play the “supply and demand” game, flood the open market with short-term bonds and make their price decrease (and increase their yields); and buy out a bunch of long-term bonds, thus increasing their price (and decreasing their yields). This will influence – only indirectly – the short term interest rates (upward) and the long-term interest rates (downward).

Operation Twist was a failure back in the 1960s. It will be a failure now. Why?

Because there is more involved in the price of Treasury bonds than simply the supply and demand. There is also the factor called “trust.” People don’t buy a product they don’t trust, no matter what the price is. The difference in the market prices between short-term bonds and long-term bonds is due to the lack of long-term trust in the Federal government. Investors just don’t believe the Federal government will be able to make good on its promises long-term. They find it risky to invest in it expecting yields 10 or 30 years down the road. No one knows if the Federal government will have the money to repay in that long period. It may default next year and cancel all its debts, who knows. The investors are not stupid; they know the risk is high, and they are unwilling to take it. The most they can trust the Federal government is in short-period of time: 3 months to a year, maximum. The are all looking for short-term bonds. This drives the market price up, and the yields down, but they don’t care. They are perfectly willing to settle for 0.01 per cent a year at low risk than for 4.3% at high risk. The high risk of default in the long-term makes them discount the long-term bonds. The discount is higher than the 4.3% yields. So they stick to their short-term bonds.

Operation Twist won’t change the distrust into trust. It can’t make the Federal government more trustworthy. It can only try to manipulate the prices – for a little while. What Operation Twist is going to do is make the Federal Reserve buy that long-term risk that no one else is willing to buy. Because investors with money can’t be forced to take the risk, the Fed will take it, in the name of every American and the whole American economy that depends on the US Dollar, forced on it by the law as “legal tender.” If the Federal government defaults, the Federal Reserve will be left with the worthless bonds, and the money it printed without any backing to buy government debt will be in the economy, producing more inflation.

Meanwhile, the investors will take advantage of the Fed’s generous offer to take the risk for them, and will buy all the short-term bonds it sells, and will gladly capitalize short-term on the long-term risky bonds. Why not? After all, that’s what the Fed is there for: Transfer the risk from the big banks to the population in general, and thus protect the banking system from the foolish decisions of its managers and the government bureaucrats. After the market has consumed all the short-term bonds the Fed is able to offer, the prices will go back to their previous levels, the yield curve will go its previous level, and the market will restore its equilibrium, which is determined entirely by the lack of trust in investors. And just like in the 1960s, Operation Twist will be a failure. And the American families will be left to pick up the tab.

And the Fed’s bosses know this. But they are desperate. They need find a justification for the existence of the Federal Reserve, even at the expense of America itself.

Which means that the Fed must be ended. The sooner the better.