Only result of US Fed's 'Twist' will be a sprained ankle

by R Jagannathan

Last Wednesday, the US Federal Reserve Board announced that it would do a Twist.

No, the old coots on the board are not heading for the nearest disco to shake a leg. They are, in fact, telling the world that they are rapidly running out of options, and playing their last card.

Put simply, the Twist is like a portfolio shuffle. The Fed will sell a part of its short-term bond holdings and buy long-maturity ones instead of a value of upto $ 400 billion by June 2012. The idea: to reduce the cost of long-term borrowing, and nudge people to start investing in mortgages and other projects.

To be sure, the Fed is free to keep trying different steps - including the Twist - to get its act right. But there are good reasons to think that Twist is not going to set America back on the growth path. Worse, it may actually be shooting itself in the foot.

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[caption id=“attachment_92742” align=“alignleft” width=“380” caption=“US Federal Reserve Building is pictured in Washington. Reuters.”]  [/caption]

Let’s see what happens when you sell short-term bonds and buy long. It increases the prices of long-term bonds (and lowers the yield) and reduces the prices of bonds at the short end. This means countries and investors sitting on short-term bonds will make losses.

China, with over $1.17 trillion in US Treasury bonds - including short-term ones - is not going to sit idle and let the value of its portfolio fall. It could well be tempted to do a reverse Twist - sell long-term bonds and buy short-term ones. If it does this, it will end up negating the Fed’s Twist.

In fact, if the Fed actually succeeds in getting short-term bond prices down, it makes sense for commercial China and other countries to invest in them anyway - for they will be cheaper and less riskier.

The Twist is a game two or more people can play - and there is no certainty that the US Fed will win the game.

The other problem is that the Fed will be working against its own interest. As any money market theorist knows, long-dated bonds are the most vulnerable to interest rates. When interest rates rise, the prices of long-dated bonds fall.

So if the Fed buys more long-term bonds, its holdings of long-maturity treasuries and other assets will go up relative to short term assets.

And, if the US economy actually starts growing and interest rates are finally raised to deal with inflation, the Fed will see large bond losses on its books as its long-dated bonds decline, says David Malpass, a former Treasury department official in the Reagan administration.

For the Fed, the Twist is a tacit acknowledgement that nothing it has done so far has worked. This may be why three of the 10 members on the Federal Open Markets Committee voted against the Twist.

All it is likely to get for the Twist is a sprained ankle.