Someone who thinks a change in the composition of the Federal Reserve’s balance sheet (a new Operation Twist) would be a good idea.
Guess who? (Obviously it’s not Bill Gross).
OK then, Goldman Sachs.
Some commentators have expressed concern that by lowering term premiums and flattening the yield curve, the Fed may damage the financial system and harm the recovery. We certainly see the potential for some negative side effects. For example, our equity research analysts believe that lower long-term rates would be a negative for most financials. Banks in particular may see reduced net interest margins due to lower loan and securities yields—though this could be partially offset by better economic growth.
Nevertheless, we still expect a net positive impact on financial conditions and the economy as a whole. Importantly, key Fed officials seem to share this view. For example, Brian Sack—head of the New York Fed’s Markets Desk—showed in earlier research that declines in the term premium have historically been associated with faster future GDP growth.
The Term premium being the excess yield that investors require to commit to holding a long-term bond instead of a series of shorter-term bonds. (And the key component of the premium being investor expectations about the future course of short-term interest rates over the lifetime of the long-term bond).
Chairman Bernanke has also argued in the past that a lower term premium could stimulate activity: “To the extent that the decline in forward rates can be traced to a decline in the term premium … the effect is financially stimulative … if spending depends on long-term interest rates, special factors that lower the spread between short-term and long-term rates will stimulate aggregate demand” . We therefore believe that concerns about negative side effects from a flatter yield curve will not stand in the way of easing.
So now (cough) the objections have been dealt with we can move on and consider what the Fed, might buy and sell…
Our best guess is that the Fed will concentrate the majority of its purchases around the 7- to 10-year point on the curve, but also moderately increase the share of purchases in the 10- to 30-year sector (it currently allocates 6% of its purchases resulting from MBS reinvestment to this part of the curve). The figure below shows the Fed’s holdings and the amount of securities available for purchase in the market.
… and what the Fed might say in its statement on September 20th/21th.
Goldman’s Zach Pandl reckons we’ll get the broard parameters of the Twist — the purpose, the timeline and the dollar amount — and confirmation from the Fed that it will continue reinvesting the proceeds from its Treasury and MBS portfolio.
But what would really be interesting, says Pandl, is whether — as hinted by FedWire on Thursday — the Fed also makes changes to communications policy — i.e. tying policy to unemployment — or cuts the interest on excess reserves (IOER) rate.
Update: 1.37pm (London Time)
Here’s the paper co-authored by Brian Sack—head of the New York Fed’s Markets Desk, and referred to above.
The three Fed stooges (and Mr Gross) – FT Alphaville