Thoughts on the Fed’s Twist
The Twist in essence reduces to a bank subsidy. How?
- Banks are taken out of levered long duration Treasury paper at cycle lows.
- Banks increase their net holdings in the short end on a levered, positive carry basis (by repo-ing purchases of short paper with the Fed).
Is the Fed’s solvency at any lesser or greater risk? NO.
- Despite the duration extension of the Fed’s balance sheet, there is no incremental risk.
- The Fed must now, however, be THE BID for the long end.
- Real risk to bondholders, regardless of duration, is dollar devaluation (real risk), not rising interest rates (nominal risk).
So, in the near term, banks win, Fed breaks even, dollar and unlevered bondholders risk of devaluation is escalated.
Where from here?
- Incremental QE is no more or no less needed as a result of The Twist.
- Incremental QE is ABSOLUTELY still necessary to shrink the unreserved debt to base money stock ratio.
- Future QE may very likely require the Fed to bid out through the long end to defend yields across its holdings maturity spectrum.
In sum, this is a move to help recapitalize banks under the guise of supporting the housing market and any wealth effect that might flow from that outcome. This is all about the banks income statements. Future and imminent QE will be about their balance sheets (dollar devaluation which then boosts nominal asset/collateral pricing).
***UPDATE – In response…
…to a question we’re getting about banks getting hit today because conventional wisdom suggests narrower net interest margins from owning short duration paper will hurt bank profitability:
We don’t think this thinking is supported by market incentives. First, money center banks were just provided with capital gains. They were taken out of long duration bonds 100 basis points to the better. That helps their balance sheets today. Second, narrower net interest margins in the future from owning shorter duration maturities can be offset by bigger and safer balance sheets (in terms of funding) — smaller margins, much bigger volume and much shorter duration. And ask yourself this: what’s the average duration of a bank’s loan demand presently? We would guess it is less than five years, if not three years.
We think this twist is just the latest permutation of bank aid. Frankly, we cannot remember the Fed doing anything that threatened bank profitability.
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Copyright © 2011 · Lee Quaintance and Paul Brodsky of QB Asset Management
Published by kind permission of the authors