In a press release from the Federal Open Market Committee released on September 21 indicates that by June of 2012, the Federal Reserve is going to simultaneously sell $400B worth of shorter-term securities and purchase $400B of longer-term securities. Some refer to this decision as “operation twist.” The expected effect of this maneuver will be to place downward pressure on longer-term interest rates. The Federal Reserve is expecting that the average maturity of bonds in their portfolio will rise from 75 months currently to approximately 100 months by the end of 2012.
The extended impact of this decision will be felt through the economy for many years to come, so it is critically important to understand exactly what the decision really means. Since the active part of “operation twist” will spur a second-level effect, we are prefer to think of it as a “double twist.” Specifically, we expect for there to be two stages in the double-twist. The first will be when the systematic shift toward longer-term treasuries in the Fed portfolio takes place, and the second will be when past monetary expansions roll through in the form of continued, persistent price inflation.
Double-Twist: Stage 1
The first part of the double-twist is what has already been communicated by the Federal Reserve. Specifically, the simultaneous purchase of longer-term treasuries and mortgage backed securities while shorter-term securities of the same type are being sold. The Federal Reserve is estimating that market uncertainty over the global economy will keep short-term capital in US treasuries for a significant period of time, and that selling their short-term treasuries will have a minimal impact on short-term interest rates. When this initiative was announced, it did very little to calm jittery markets, and key indexes continued their downward trajectory. It is most likely that the reason for this is because market concern is not in regards to the price of credit, but rather in regard to the fiscal problems of the United States government that are not on any meaningful path to resolution.
The government is currently spending approximately $1.5 Trillion dollars more per year than is collected in revenue. All of this additional debt is either purchased by the Federal Reserve or must be floated out on the open market. To date, the Federal Reserve has purchased a massive amount of US government debt, which has had an inflationary effect on prices for goods and services. The reason for this is because when the Federal Reserves buys Treasuries from the open market, it pays for them with a credit to the bank’s reserve deposits. This ultimately means that the net amount of money in circulation increases. Furthermore, the banks who just sold their bonds to the Fed can now loan out the money they just received at a 10 to one ratio. Thus, large purchases by the Federal Reserve have the ability to create large amounts of inflation very quickly as the amount of money in circulation grows faster than the amount of goods and services in the economy.
Double-Twist: Stage 2
Now comes the second act of operation Twist, which we contend turns it into a double-twist. As the Federal Reserve actively works to suppress the interest rate of longer-term securities, it is effectively locking in long-term monetary inflation and negative real interest rates. This is resulting because the Fed is printing money to subsidize low interest rates while that new money floods into the economy, pushing up prices.
By reducing the amount of short-term treasuries held by the Federal reserve, this decision is effectively locking-in negative real interest rates and inflation as long-term policy. This is especially true since the Fed will now need to take more aggressive action if it wishes to reduce the money supply in response to price inflation that is likely to result from its repeated injections of capital into the market.
Consider that if the Fed primarily owns short-term treasuries, it can simply let those notes mature and naturally pull money out of circulation as those notes are repaid. However, if the majority of Fed holdings are longer-term treasuries, the only way that they can pull money out of the market is by selling these treasuries. When these sales happen, it will suppress the price. When the prices are pushed down, it will increase the net rates. When the rates of these treasuries increases, it will also increase the interest rate of associated credit such as mortgages. When the price of credit increases, it will suppress the price of credit based assets such as housing. This will create a major head-wind against whatever form of economic recovery is beginning to emerge.
Since the Federal Reserve will be very reluctant to take an action that actively suppresses the economy, it is highly likely that they will simply allow prices to continue inflating. This will place significant pressure on people who rely on pensions, government assistance, bonds, and fixed-income retirement programs. By shifting the Fed portfolio toward longer-term securities, it is locking-in this effect.
What Double-Twist Means For You
The extended impact of this maneuver is that people who purchase cash producing assets with fixed-rate debt will be made wealthy. The way that this effect will take place is through price inflation that pushes up the cash flow and price of these assets while the cost of capital remains fixed by the interest rate. The way that you can benefit from this effect is by gaining ownership of assets that produce cash flow and are financed with fixed-rate debt. The most typical way to take advantage of this effect is with rental real estate. The effect can also be captured to a lesser degree by acquiring stocks that pay high dividends from their earnings.
In both cases, the important part is to own assets that will have their value and cash flow pushed upward by inflation. This will put the impact of inflation in your favor, as the purchasing power of cash, debt, and fixed-income payments is eroded. In this manner, the debt you use to purchase your assets will be eroded by inflation while the value and cash flow from your assets are enhanced. In the current environment, this is possibly the best path to wealth that exists for investors who are not corporate insiders or affiliated with prominent politicians.
Source by Doug Utberg
