Friday, 23 September 2011

Bitter and Twisted (or what the Fed are doing and why everyone hates it)

The legendary investor, Benjamin Graham, once said "In the short run, the market is a voting machine, but in the long run it is a weighing machine." The Republican leadership may have misunderstood the reference as this week they made an unprecedented foray across the hallowed ground of central bank independence, apparently begging the Federal Reserve Open Markets Committee (FOMC) not to engage in any more unconventional monetary policy.

Nevertheless the FOMC used their discretion, the markets cast their votes and the Republicans appear to have won.

What Graham's voting/weighing quote means, however, is that in the short term opinions or votes move markets whereas in the long term true value comes to the fore. The FOMC will be hoping that the long term demonstrates they’re more valuable than popular!

What's the Fed doing?
Operation twist is designed to lower mortgage costs. It involves selling $400bn treasuries (loans to the government) with less than three years to run and using the proceeds to buy an equal value of treasuries with between 6 and 30 years left to run.

By doing so the price of those loans should rise and, because bonds pay a fixed regular income payment, the yield (regular payment divided by price) will fall. This means that other securities priced against treasuries' rates of interest will have lower yields and should therefore lower borrowing costs. This is particularly true for long term fixed rate mortgages which make up a significant percentage of the US mortgage market.

Why does everyone hate it?
Why did the market react so violently following the announcement? There are several explanations; coincidence, sentiment, desperation or, everyone's favorite, policy error.
There have been a few suggestions that operation twist will kill credit creation. This is an interesting topic for those that way inclined (if you are, please see will twisting cause lending to stick?”). Some argue that it removes the incentive to lend – which is debatable.

Other explanations include:
·  It could be the miserable tone of the statement accompanying the action.
·  It could be coincidence as the news came on the same day Citigroup, Wells Fargo and Bank of America received credit downgrades.
·  It could be because shock and awe is not an appropriate tactic this time round. The program was larger than anticipated but has left some with the impression that the Fed has nothing left for a rainy day.

Whatever the reason the Fed will be massively disappointed with the outcome. They have historically placed real faith in the ability of the positive voting machine to improve the mood of the nation. Now they’ll have to wait and see what it weighs…


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