Operation Twist: Will It Work Or Is It Just Twisted?

By this point, many people may have heard about Operation Twist. No this is not a new military campaign, but and economic campaign to try to keep the economy moving forward. But what exactly is it?

Operation Twist is a plan to lower interest rates, or continue to keep them low, by purchasing long term bonds. Why does this work and what are the implications of such actions?

The idea behind the Fed's purchases is by buying bonds, the price of the bonds will increase. It is simple supply and demand. This in turn lowers the interest rate. However, this is a common grammatical error. The yield to maturity is lowered; the interest rates on the bonds do not change. The yield to maturity, or YTM, is simply the interest rate you earn by holding the bond until the maturity date, i.e. the date the loan is paid back. It is calculated by taking the price you pay for the bond and dividing it by the amount of money you receive yearly in interest payments.

To understand this we also must understand bonds are sold at par, premiums and discounts. What is the difference? Par is 100%. So a $10,000 bond is sold at $10,000. A premium is sold over 100% and a discount is a bond on a blue light special, or selling for less than 100%. So when there is a higher demand, prices will increase and the YTM decreases.

Interest Rate

Price

YTM

4%   ($40/yr in interest)     

$1000 (par)

4.0%

4%   ($40/yr in interest)

$1200 (premium)     

2.5%

4%   ($40/yr in interest)

$  800 (discount)

5.0%

The question I often get is why someone would pay a premium for a bond? If the interest rates in banks are low, then people look for investments that offer a better return.  In the case above, if banks are paying 2.0% then people might look to purchase US treasuries (bonds) because those pay 4%. As people begin buying these bonds, the demand increases and prices rise. Prices will continue to rise and the YTM thereby falls to a point where people see the risk/reward of investing in government securities equal to that of banks.

How does this translate into helping the economy? Like you, banks want to earn money.  They do so by making loans to people, business and other banks.  Any excess money they have can be used to purchase bonds.  This is where “Twist” comes into play. When the Fed buys bonds, banks have an incentive to sell their holdings. This leaves the bank with additional reserves. Because the bank does not want to keep reserves on hand, they try to lend it out. To entice people to borrow money, banks must lower interest rates.

The Federal Reserve is doing this by selling short term notes (loans) and buying back long term bonds. Depending on what you read there are repercussions to this as well. Having the Fed sell short term notes should drive down the price of these two-year loans and increase the YTM. Banks will recognize an opportunity to invest its reserves into these short-term notes and potentially drive up the interest rates on short-term individual bank loans, the complete opposite effect the Fed wants.

Also, with interest rates already at an all-time low, will potentially lowering long term rates further help? It may a little. Unfortunately I feel we have maxed out our borrowing and refinancing. People aren’t borrowing enough and banks are not leading money like they once were. One of the reasons for this is because banks do not want to tie up their money for 30 years at low interest rates. Banks know rates are going to increase in the next 30 years so why should they loan money to everyone? This is why only people with the top credit scores are able to get loans. A bank would be silly to tie up their money for a long term to someone with a lower credit score.

Unfortunately I am skeptical in doing the Twist. I know the Federal Reserve is trying to do something and for that I commend them. The government is too tied up in political ideological gridlock to do much and we the people do not understand enough of how the economy works to propose unique partisan solutions. Unique economic solutions usually amount to not understanding and doors being closed to these ideas. Until then, at least someone is doing something.