Wednesday, September 21, 2011

US is flirting with another financial meltdown----By Shan Saeed

The Fed has resurrected an old tool of monetary policy. The central bank will buy longer-dated Treasury bonds and sell shorter-term notes. It’s based on a 1961 policy that the Fed implemented called “Operation Twist.”
The notion is pretty simple. By buying longer-dated Treasurys, prices will rise and long-term interest rates will fall. Lower long-term interest rates may help spur investment. By selling short-term securities, their prices will fall and their yields will rise, attracting foreign capital.

For the average investor, the potential changes could be huge. If the Fed is successful in lowering long-term rates, investors could get even lower rates on mortgages, while enjoying higher rates on short-term investments like T-bills and money market accounts. Simply put, if all goes according to plan, Operation Twist would lower expenses and increase income for most investors.
Unfortunately, even with history as a guide, the first Operation Twist was so modest in scope that it’s difficult to determine if it will work now. I think it will remain ineffective.
The program remains smaller in scope than the Fed’s quantitative easing programs. Only $400 billion will be re-deployed in this operation through the end of June 2012.

Despite the smaller size and the fact that this policy won’t make any substantial changes to the size of the Fed’s balance sheet, the program received three dissenting votes from the Fed’s 10-member committee.

Data Remains Weak, but Fed Holds on Interest Rates and Other Measures

With this weak showing in the economy, the Fed left interest rates unchanged, in line with its earlier meeting announcement to keep interest rates near zero through mid-2013. Negative data coming out in the past few months shows that the economy continues to weaken. In the second quarter of 2011, U.S. GDP grew at a weak 1 percent. Over the past few Fed meetings, the central bank has still not ruled out other means, to stimulate the economy and to keep asset prices from plunging.

Many market watchers expected Operation Twist to take precedence over another round of quantitative easing, as the first two rounds of the controversial program did little to stimulate the economy. Some economists derided the program as mere money-printing that fueled inflation. Others predict more QE from the Fed in the future.

I wrote about the possibility of a mega mortgage ReFi by Fannie and Freddie few weeks back. I already pointed out to an obvious flaw in the ReFi story. If a Trillion or so of mortgages were rapidly prepaid, then who would buy all of the new (much lower coupon) mortgage paper?

Now we have the answer. The Fed will put the new MBS paper back on its Balance Sheet, $ for $. There will still be many bondholders outside of the Fed who will get prepaid much faster than they had assumed. Most of that is in pension/bond funds. No one cares about them. I think that Treasury will announce the plans for a Mega Refi in the not too distant future. It could come this weekend or next week. Obama will wait just enough time after the complex Fed decision so that 99% of all people don’t connect these two dots.

I expect the Fed to announce additional quantitative easing. This action will scotch the fear trade, tighten credit spreads and send treasury yields higher.

Disclaimer: This is just a research piece and not an investment advice. All financial transactions carry a RISK.


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