Operation Twist, Part Deux?

Who funds our budget deficit? It is a question taking on increasing significance, given the recent back up on longer-dated bond yields, which has been explained by many as a “buyers’ strike” in response to growing government profligacy. We think this argument displays a seriously lagging understanding of how much modern money has changed since Nixon changed finance forever by closing the Gold window in 1973. Now that we’re off the gold standard, neither our international creditors, nor the so-called “bond market vigilantes”, “fund” anything, contrary to the completely false & misguided scare stories one reads almost daily in the press.

In his usually effective fashion, Bill Mitchell debunks the notion that “the markets” determine our interest rate structure, as opposed to the central banks. Mitchell discusses this in the context of his analysis of a BIS paper, “The Future of Public Debt: Prospects and Implications”, which raises the old canard about a potential “bond market buyers’ strike” as a consequence of rising public debt.” “[T]he debt ratio will explode in the absence of a sufficiently large primary surplus”, argues the author of the BIS paper.

From which – Mitchell deduces- “the governments [should] either stop allowing the bond markets to determine yields – that is, use their capacity to control the yield curve or, better still, abandon the practice of issuing debt.”

Mitchell then poses the question: “Why will yields spike dangerously so that real interest rates exceed real output growth rates? There is no answer to this question provided.”

There is no answer provided because, as a point of economic logic, Bill’s critique of the BIS is (as usual) unassailable. BUT as any regular observer of the markets can tell you, bonds have begun to rise again over the past few weeks, notably in the US. This might have occurred for the dumbest reasons imaginable (one person foolishly tried to link the rise in US yields to Portugal’s downgrade by the benighted ratings agencies).

On the other hand, one of the great insights of George Soros was the notion that markets could act on incorrect or imperfect information and thereby create a new kind of economic reality. It might well be that very few understand MMT or basic public reserve accounting, but that doesn’t alter the reality that bond yields have risen 20 basis points in the past week or so. And a central bank which is underpinned by a market fundamentalist ideology, coupled with a bunch of “big swinging dicks” in the trading pits is a potentially toxic combination. The Fed follows the price action at the long end of bond market. Long bond investors often try to force Fed’s hand. Around and around they go,dog chasing tail style.

There’s a power dynamic here – who’s really in control: Big Swinging Dick Finanzkapital (BSDF)or policy geeks who understand basic public reserve accounting?

The Fed clearly has a dilemma. It needs to finesse expectations management for BOTH Treasury bond and equity investors. Bond investors need to know they are not going to get screwed by inflation, so they want the fed funds rate renormalized. Equity investors want the “extended period” of ZIRP to last for, well, an extended period. Free money is good for specs.

So what’s a central banker like Bernanke to do?

How about a modern version of “Operation Twist”, which was implemented originally by the Fed in 1961 to flatten the yield curve in order to promote capital inflows and strengthen the dollar. The Fed utilized open market operations to shorten the maturity of public debt in the open market. It was only marginally successful back then.

So why should it work better today?

Well, the Fed has more tools in its policy box, thanks in part to its policy of paying interest on excess reserves (IOER). Scott Fullwiler has an excellent paper on this (“Paying Interest on Reserve Balances: It’s More Significant than You Think”), in which he demonstrates that this change in Fed policy has severed the relationship between the policy rate target and the level of reserves outstanding (if there ever was one – some indications in recent years were that all Fed had to do was announce new fed funds rate target, and primary dealers would take it there, knowing Fed had capacity to change reserves outstanding – all of which meant Fed did not have to change reserves, since they had a credible threat they could, making the textbook story about Fed ops even more outdated and incorrect).

So the Fed can tell everybody that they are renormalizing the fed funds rate and take the IOER up to 100bps. Note, the Fed does not need to remove any reserves to do this – they can just do it administratively. That’s how the IOER works – it severs the link between reserves in the system and the target policy rate, right?

Then, if the bond gods don’t rally Treasuries on the Fed’s efforts to renormalize the policy rate, Mr Bernanke calls up Bill Dudley (President at the NY Fed) and gives him instruction to buy all the 10 year UST on offer until the 10 year UST yield is down to, oh , say 3.5%. It is an open market operation, which the Fed performs all the time. They won’t have to call it QE, but it is in effect the same thing.

Then, every time some big swinging dick bond trader tries to push it above 3.5% by shorting Treasuries, the Fed slams their face into the concrete by having the open market desk buy the hell out of UST until the 10 year yield is back to 3.5%. Burn Fido enough times, yank his chain enough times, and like the Dog Whisperer, he gets it and stops.

No less than one of the leading “bond market vigilantes” has conceded this point. In his October 2003 Fed Focus, PIMCO’s Paul McCulley has acknowledged that “any market induced—foreign or domestic-driven—upward pressure on U. S. intermediate or long-term interest rates would/will be limited by the leash of the Fed’s . . . anchoring of the Fed funds rate . . . . Put differently, there is a limit to how steep the yield curve can get, if the Fed just says no—again and again!—to the tightening path implicit in a steep yield curve”.

What happens if the 10 year bond breaks out of the 3.5% to 4% range significantly even with no changes in expectations regarding the Fed? Could that happen, or is there some arbitrage mechanism that brings it back? Of course, there will always be smart bond traders (such as our friend, Warren Mosler), who will understand the potential arbitrage opportunity at hand and react accordingly, but a signal from the Fed that it desires a certain rate level or term structure for rates will facilitate the process.

Operation Twist, Part Deux, then? It strikes us as the optimal way to finesse the expectations management dilemma.

It seems to us that we are now approaching a very critical juncture in terms of potentially settling the debate between those who think that central banks establish the rate structure (as most readers of this blog believe) versus those who believe that this is done by the markets (such as the usual band of deficit hawks, and the writer of the BIS report critiqued by Bill Mitchell). Of course, like most MMT adherents, we feel that the whole debate would become less relevant if the US Treasury responded to today’s environment through sensible proactive fiscal expenditure, but it’s hard to sustain political support for that amidst sock puppet politicians who dole out goodies to their corporate contributors, and an Administration which genuinely believes we’re “running out of money”.

That places an unnecessarily large burden on the Fed, hardly an appealing prospect, given Mr Bernanke’s own neo-classical economics framework. Keynes himself was quite explicit about the importance of investor portfolio preferences in determining interest rates specifically. Indeed, Ch. 12 of “The General Theory” is all about the beauty contest aspect of asset price determination in the face of fundamental uncertainty and asset markets organized to optimize liquidity for existing holders. Does the Fed understand this? It may well not happen, but no question an aggressive move to counter short term portfolio preference shifts on the part of private investors could do much to resolve this “who determines rates” question once and for all.

There’s a power dimension here. Does the Fed really want to be led around by the nose by the very same people who created today’s economic disaster?

About Marshall Auerback 37 Articles

Marshall Auerback has 28 years of experience in the investment management business, serving as a global portfolio strategist for RAB Capital Plc, a UK-based fund management group with $2 billion under management, since 2003. He is also co-manager of the RAB Gold Fund. He serves as an economic consultant to PIMCO, the world’s largest bond fund management group, and as a fellow of the Economists for Peace and Security.

From 1983-1987, he was an investment manager at GT Management (Asia) Limited in Hong Kong, where he focused on the markets of Hong Kong, the ASEAN countries (Singapore, Malaysia, the Philippines, Indonesia, and Thailand), New Zealand and Australia. From 1988-91, Mr. Auerback was based in Tokyo, where his Pacific Rim expertise was broadened to include the Japanese stock market. From 1992-95, Mr. Auerback worked in New York for the Tiedemann Investment Group, where he ran an emerging markets hedge fund. From 1996-99, he worked as an international economics strategist for Veneroso Associates, which provided macroeconomic strategy to a number of leading institutional investors. From 1999-2002, he managed the Prudent Global Fixed Income Fund for David W. Tice & Associates, an investment management firm, and assisted with the management of the Prudent Bear Fund.

Mr. Auerback graduated magna cum laude in English and philosophy from Queen’s University in 1981 and received a law degree from Corpus Christi College, Oxford University, in 1983.

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