Alert September 28, 2011

The Fed Tries a Twist

The Federal Reserve recently initiated a “sell short, buy long” bond strategy in an effort to stimulate the current stagnant economy.  Under this strategy, dubbed “Operation Twist,” the Fed will sell $400 billion of maturing short-term bonds (6-month to 2-year maturities) and use the proceeds to buy long-term bonds (5-, 10-, 30-year maturities). President Kennedy tried a similar strategy in 1961, partly to discourage investors from selling dollars for gold and then selling the gold in Europe for a profit, and partly to provide stimulus by keeping long-term rates lower. The program was originally thought to be a failure, but some economists think that it was effective after isolating certain statistics.

Operation Twist sparked a massive sell-off in stocks and continued an unprecedented bond market rally, driving the 10-year Treasury yield down to 1.71%, the lowest yield since the 1950s. It is difficult to predict, however, how much real stimulus will result from this strategy. Interest rates have been at historic lows for an extended period and the economy has remained unexpectedly unresponsive to traditional stimulus.  Will lowering interest rates prompt consumers and businesses to spend on houses, cars, and hiring? Or is the fear of an uncertain future at the heart of our stagnant economy?