An operation with a Twist

Eamon Cargo, Butterfield Market Watch

On Wednesday, 21 September, 2011, the Federal Reserve announced a slightly different plan called Operation Twist, which involves selling approximately $400 billion in short-term Treasuries to purchase a similar amount of mid to long-term Treasury bonds. The operation will commence in October and will be ending around June 2012.

While it will not increase the amount of money that is in the economy, it will have an impact on keeping longer term bond yields lower for an extended period of time. At the same time, the selling of the shorter term securities will have little impact since the Federal Reserve Chairman Ben Bernanke has stated that the Federal Reserve is committed to keeping the Fed Funds target rate at zero to .25 per cent until mid-2013 at the earliest.

There is an old saying on Wall Street: “Don’t fight the Fed”. If the Federal Reserve announces they are going to take market action to lower interest rates, it means that it will most likely happen. You would not want to be taking the other side of the bet that the Federal Reserve cannot pull it off.

Because of the announcement, investors saw the 10-year US Treasury hit an intraday low yield of 1.695 per cent on 22 September from a high of 3.18 per cent on 1 July. The five-year US Treasury fared the same, hitting an historical low yield of 1.015 per cent on 28 September from 1.58 per cent on 28 June.

What are the positive effects of a decrease in interest rates?

The anticipated positive effects will be to push interest rates down on almost everything from mortgages to business loans. The intention is to entice consumers to borrow and spend more money. In effect this has worked for mortgages rates. As of 6 October, 2011, an average rate for a 30-year fixed rate mortgage hit an all-time low of 3.94 per cent.

What are the negative effects of a decrease in interest rates?

Typically banks will borrow short and lend long. What this means is that they will take overnight deposits and buy treasuries or loan out a portion of the money to individuals or businesses. In the example of banks buying treasuries, they will purchase securities with several years to maturity. The problem with interest rates so low is that there is little to no incentive to take on the risk of purchasing two year treasuries yielding 0.18 per cent.

The only other option is to loan out the money to individuals or corporations. The issue is that banks are having a difficult time finding qualified willing borrowers. Since 2008 there has been a mass movement for people and businesses to de-leverage so the pool of people or organisations that are willing to borrow or qualifies has greatly diminished.

Here is the twist.

The Federal Reserve’s actions are now hurting the return to net savers. It is causing a disincentive to the saver by punishing them with such paltry yields. With interest rates at historic lows, why would an investor want to purchase 10-year US government debt and lock in an interest rate of 1.695 per cent a year? Such low interest rates will most certainly provide a negative return when factoring in inflation.

What to do as a saver?

As a saver and investor, it would be wise to build up a large position in cash. Any money that will not be needed for several years could be used to slowly ladder into five-year CDs or gradually dollar cost average into stocks or ETFs (Exchange Traded Funds) that have reasonable yields. Many ETFs including DIA and SPY have yields above 2 per cent. Even consumer staples (XLP) and utility (XLU) ETFs should result in healthy yields of 2.6 to 4.0 per cent.

Disclaimer: The views expressed 
are the opinions of the writer and 
whilst believed reliable may differ 
from the views of Butterfield Bank (Cayman) Limited. The Bank accepts 
no liability for errors or actions taken 
on the basis of this information.