MNI EXCLUSIVE: Fed Twist Would Need Severe Market Disruption

The Federal Reserve would have to see a credit market freeze that threatens the economic recovery before it extends the maturity of its bond purchases in an Operation Twist or makes another significant monetary intervention, former Fed officials told MNI.

Despite mounting investor speculation of Fed action, the central bank is likely to look through the rapid rise in long-term Treasury yields and even welcome them as a sign of an improving outlook, the sources said.

"A big bond market intervention doesn't seem to be in the cards -- it's their heavy artillery," Jeffrey Lacker, former Richmond Fed President, told MNI, calling the recent yield spike just "a little bit of a conniption."

"Market participants made too much of some things that were temporary reversals of the Covid episode," he said.

The 10-year Treasury yield has risen 60 basis points to 1.6% this year, driven by stronger growth and inflation expectations as vaccine rollouts gain steam and fiscal stimulus ramps up.

TWIST PREDICTIONS

Some on Wall Street predict a Twist as early as next week's meeting. There has also been revived talk of yield curve control, though the Fed has signalled any such move would be a last resort, and targeted at shorter maturities.

However, with rates already effectively at zero and the Fed purchasing USD120 billion per month, it is loath to intervene further in bond markets. An Operation Twist would involve reducing shorter-term debt buying in favor of longer-term assets, and was last undertaken in 2011.

Chair Jerome Powell and Governor Lael Brainard both recently said they are watching developments closely and would not welcome "disorderly" markets or tightening credit conditions that threaten progress toward Fed goals.

"Yields aren't so high, they were about at these levels before the pandemic," said Charles Steindel, former senior economist and vice president at the New York Fed. "It's a little bit more of a normalization than anything else. I don't think the Fed was ecstatic about the ten-year yield below 1%."

Underlying the tensions is an argument about how much of the rise in yields is nominal and how much in excess to inflation -- and thus potentially constraining for economic activity.

The bar for Fed intervention in response to rising 10-year yields, other than verbal jousting, looks very high for two key reasons.

First, if yields are rising due to higher inflation expectations, it is unclear additional monetary stimulus is the right medicine. Inflation expectations have indeed ticked gradually higher, in line with the Fed's desire to push them closer to target.

Second, officials have signaled their next move, however distant, will be a tapering of bond purchases. Adding stimulus would represent a major shift in course and signal a high level of concern to markets.

WRONG SIGNAL, WRONG TIME

William English, former director of the Fed board's division of monetary affairs, told MNI he sees no need for either Twist or yield curve control, either of which would also be problematic from a communications standpoint.

"If the market started to build in rate hikes next year and the committee really thought that wasn't right and just talking about it wasn't doing the trick, then maybe they would conclude that financial conditions had tightened too much and they needed to try to ease financial conditions," English said. "That's when you might think about an Operation Twist."

For now, it would be hard for the Fed to justify more support for a strengthening economy. Improving vaccine distribution and availability is boosting prospects of the U.S. reaching herd immunity by summer, allowing for the resumption of activity in the giant services sector.

Meanwhile, Congress has approved another fiscal relief package for USD1.9 trillion. For the Fed, these are welcome developments rather than something that requires leaning against.

"If you shifted the purchases from short to long, that would look like you're providing more accommodation and that might be pretty hard to explain in a situation where the outlook has improved," English said.