Doing the Un-Twist

June 12th, 2013 by Rick Drain

Back in September 2011, the Federal Reserve announced a new policy initiative. As part of their attempt to resuscitate the economy (with no help from Congress’ fiscal tightening), they launched Operation Twist.

The Fed wanted to “twist” the curve of interest rates for various maturities of Treasury debt. Specifically, it wanted to force down the yield for long T-bonds, by buying those while selling short-term bonds as a balance. The goal was to encourage more long-term investing, by lowering long-term interest rates. As they hoped, Treasury rates were pushed down, and commercial long-term rates fell too.

Treasury rate curve

You can see in the chart that a year ago, long term rates (for example, ’10y’ means 10-year maturity) had been driven down to between two and three percent.

Without actually announcing a plan, a bit over a month ago they allowed the longer rates to start rising again. From the 5-year maturity onward, they’ve risen more than half a percent.

Partly, that was done by the market itself. The investment community is now seriously considering the timing of the Fed’s inevitable increases to the Federal Funds overnight lending rate (FF on this chart), and the effect that will have on longer bonds. The market did the work of bidding rates up, but the Fed did nothing to stop it with new Twist purchases.

From the Fed’s perspective, all is as it should be. The economy is recovering adequately, Operation Twist is over, and the Fed is letting the long-maturity part of the yield curve return to its natural market-set levels. This is the beginning of the beginning of the Fed’s removal of its extraordinary monetary policies for supporting the economy.