Operation Twist.

22nd September 2011

Ian Copelin, Investment Director, my wealth comments “UK equities have dropped this morning (22 September 2011), after the US Federal Reserve warned of ‘downside risks’ to the US economy.

As a result, the Fed policy makers plan to lower long-term interest rates by simultaneously buying $400bn long-term bonds with maturities of six to 30 years while simultaneously selling $400bn short-term bonds with three years or less to maturity.

This is being called ‘Operation Twist’ on Wall Street as the Fed is trying to ‘twist’ the yield curve — the line that charts the relationship between the cost of borrowing and the time to maturity. By buying the longer end, the Fed is trying to flatten the curve (i.e. put downward pressure on longer-term interest rates) which in turn should spark longer-term lending – not unlike a homeowner swapping higher-rate credit card debt for a lower-rate mortgage. By reducing longer-term rates, it is hoped that people refinance their debts and thus increase their disposable income.

Interestingly, Operation Twist doesn’t change the amount of money available for lending, it is simply reshuffling the Fed’s holdings – if the Fed was convinced of the ‘downside risks’ to the US economy and seriously thought that growth was not going to improve, they would have, and should have, been more aggressive.

Lowering rates typically pushes bond prices higher, so anyone who already owns longer-term bonds makes money. However, it also prompts investors to look at alternative investments to get better returns (such as equities). This should therefore help to support equity prices.”