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Extended Operation Twist: $267 Billion That Won't Do All That Much


The idea is to lower the interest rate of the longer bonds, which in turn is supposed to lower interest rates for borrowers.

This article was originally published on June 23 in John Mauldin's weekly e-letter.

I have often said that when someone is appointed to be a member of the Federal Reserve, they are taken into a back room and given a complete DNA change. They simply are not like you and me once they step out of that room, with the exception of Richard Fisher and Jeffrey Lacker and a few colleagues who seem to be able to resist the infection. This week we will look at the recent action of the Fed and use that as a springboard to think about how effective Fed policy can be in an age of deleveraging. And if there is time, we simply must look at Europe. I started this letter in Texas and will finish it this morning in Spain.

But first, and quickly, most of you are aware of my annual Strategic Investment Conference, co-sponsored with my partner, Altegris, which we held last month. This year's David Rosenberg (and many attendees!) said this was the best conference ever, featuring a lineup of world-class economic and financial leaders. Our very enthusiastic attendees created a room full of energy that the speakers seemed to feed off of, and everyone brought their "A" game. It really was quite special. And now we have the videos.

For those of you who are members of my special program for accredited investors, called the Mauldin Circle, you can access the conference videos by going to the "My Information" section at the bottom of your personal home page, when you log into I can't think of a better way to sharpen your investment outlook than to partake of some of the best minds in the world, including Dr. Lacy Hunt, Niall Ferguson, David Rosenberg, Jeffrey Gundlach, Mohamed El-Erian … and even your humble analyst.

In order to view the videos, you must be a member of the Mauldin Circle. This program has replaced our Accredited Investor Newsletter Program. My partner Altegris and I have worked hard to enhance the program, which now includes access to webinars, conferences, special events, videos, accredited newsletters, and presentations featuring alternative investment managers and other thought leaders and influencers.

The good news is that this program is completely free. The only restriction is that, because of securities regulations, you have to register and be vetted by one of my trusted partners, which in the United States is Altegris, before you can be added to the subscriber roster. This will be a quite painless process (I promise). Once you register, an Altegris representative will call you to provide access to the videos, presentations, and summaries from selected speakers featured at our 2012 Strategic Investment Conference.

Click here to initiate your membership in our exclusive Mauldin Experience Program. After you have talked with the Altegris representative, you'll be able to view the first set of five videos, featuring Dr. Lacy Hunt, Jeffrey Gundlach, Niall Ferguson, David Rosenberg, and Mohamed El-Erian. We will have the rest of the conference lineup for you in a few weeks. And now, let's scrutinize the Fed.

Daddy's Home

This week the FOMC of the Federal Reserve announced that they would extend Operation Twist through the end of the year by buying $267 billion in longer-dated bonds while selling shorter-dated bonds. The idea is to lower the interest rate of the longer bonds, which in turn is supposed to lower interest rates for borrowers on mortgages, cars, and business loans. The only dissenting vote was from Jeffrey Lacker (Federal Reserve Bank of Richmond President) who said he believes the move would spur inflation and not significantly help the economy. (Fisher is not a voting member this year).

Lacker remarked, "I do not believe that further monetary stimulus would make a substantial difference for economic growth and employment without increasing inflation by more than would be desirable."

Let me offer a few quick thoughts. First, $267 billion in a "twist" will really not do all that much. Look at this chart from Bloomberg. At first glance it looks like rates really do rise as the duration of the bonds increases. But when you look at the actual numbers, you see that you have to go out to seven years to get a measly 1% (more on that pitiful rate later).

The market had already taken yields on the 10-year down to 1.43% a few weeks ago, although rates have since risen slightly. The drop was a reaction to the very poor jobs report for the month of May, which suggested the economy was getting softer. If we continue to get poor unemployment reports for the summer, which I think is likely, then the market will take long rates down on its own.

The Fed actually expects rather weak economic performance. Quoting from their release, at the conclusion of the meeting:

The Committee expects economic growth to remain moderate over coming quarters and then to pick up very gradually. Consequently, the Committee anticipates that the unemployment rate will decline only slowly toward levels that it judges to be consistent with its dual mandate. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook.

The translation: The economy is not going to get much better than what we have today for the rest of the year. Growth is not going to get much better than the sub-2% that we have seen recently, and if anything else bad happens in Europe, it could get a lot worse. And if growth goes any lower, and inflation numbers continue to come in as they have recently, then rates are going down anyway.

So why did the Fed continue Operation Twist? Because the market (that amorphous, omnivorous blob) expected something from the Fed. This summer's version of Twist and Whisper was about the least they could do.

This is the economic equivalent of walking into a room full of your anxious children, patting them on the head, and saying "Daddy's home; everything will be OK now." It was basically all they could do short of another full-blown quantitative easing, and I believe they think they really need to save the QE psychological bullet for another time, when we may be in even more serious straits. (Which if you buy their rationale is the correct thing to do.)

But given their forecast, another QE is likely this year. That is really the only tool they have left in their bucket. How much lower can rates go? Even economists who think that deflation is the base case over the next few years don't think rates can go much lower than another 0.5% on the long end of the curve. For those keeping score, that would be a 2% 30-year bond and a 1% 10-year bond.

Where's All That Money Going?

For all the work that central banks around the world are doing to force liquidity into the markets, we are not seeing the results in terms of prices. Higher prices are of course what inflation hawks and gold bugs expect. For them, a rising Fed balance sheet is a sure sign of impending inflation. They have been warning of the demise of the dollar for years. I get some serious heat in question and answer sessions when I talk about a much stronger dollar. But that is based on a different understanding of what causes inflation. It is not just the supply of money; it is also the velocity of money, or how fast it goes through the system. I have done several e-letters on the concept and formula first developed by Irving Fisher in the 1930s. Here are links to a couple.

As I wrote a few weeks ago, we will see inflation in our future, but it will be preceded by the velocity of money rising. Until then we have other things to concern us.

Headline inflation is down and now below 2%, and it has been falling for some time (which is also why interest rates are coming down). Energy prices are down and do not yet seem to have found a bottom. Oil is down 25%, which will soon show up in savings at the pump, giving everyone the equivalent of a small tax break (which, unless you own an oil well or energy shares, is not bad news).

Ditto for a whole host of commodities, even including gold of late. Don't get me wrong, I am still buying gold every month. If it goes down I am happy, because that means I get more of those shiny little coins for the same amount of my paper money.

Copper is at its six-month low, and Chinese stocks of the metal are said to be at all-time highs. There are reports from serious sources that Chinese commodity buyers (of coal, etc.) have lost their financing for long-term contracts at higher prices. Supposedly, there are some 30 large ships full of coal, sitting out of port waiting for the money to clear.

No positions in stocks mentioned.

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