Operation Twist’s ETF Fallout

September 26, 2011

Last Wednesday, the Federal Reserve capitulated to market expectations and announced ‘Operation Twist.’ Now, let’s take it to the lab.

I started to do that in my last blog, detailing the various strategies for taking advantage of the new policy. So, I thought I’d point out that certain segments of the economy and some ETFs are likely to benefit from the Fed’s latest move, even though we’re at a precarious crossroad.

For those who haven’t fully grasped the details, the Fed will extend the maturity of its Treasury holdings by selling $400 billion worth of paper maturing in three years or less and reinvesting that sum in Treasurys maturing between six to 30 years.

Additionally, maturing mortgages within the Fed’s portfolio will be reinvested into the mortgage market, a policy reversal that should help reduce the spread between mortgage and Treasury yields.

The overall result should be higher short-term Treasury yields and lower long-term Treasury yields. Not surprisingly, that’s precisely how the market reacted in the aftermath of the announcement.

Treasury Yields

As part of its reasoning for undertaking Operation Twist, the Fed cited “significant downside risks to the economic outlook, including strains in global financial markets.” This didn’t sit well with market participants, resulting in a major sell-off in equity markets around the world.

Taking On The Conventional Wisdom

A common opinion in markets these days is that the financial sector, specifically banks, are likely to feel the pain of substantially lower long-term yields. The logic goes that banks borrow short and lend long, benefiting from the spread. So, as the spread narrows, banks’ profit margins shrinks.

I disagree. U.S. banks profits have for some time centered on the fees they earn from originating and servicing mortgages rather than keeping them on their books. For the most part, after originating the mortgages, banks package them up and send them along to Fannie Mae and Freddie Mac, with the U.S. government serving as the backstop.

If anything, funds focused on banking, such as the SPDR KBW Bank ETF (NYSEArca: KBE), may benefit from an increase in refinancing that appears to be taking place as a result of increases in mortgage applications and refinancing.

I recognize there are a slew of factors that can send banks into another tailspin, but I just don’t think this is one them.

Aside from the obvious impact on Treasurys, reinvesting the roll-off from maturing mortgages back into the mortgage market should drive yields lower for mortgage-backed securities, benefiting funds such as the iShares Barclays MBS Bond Fund (NYSEArca: MBB). It’s important to keep in mind that because of the prepayment feature inherent in MBS securities, increases in price diminish as yields go down.

Despite what seems to be the common opinion, the Fed’s operation twist may foster growth, without actually increasing the Fed’s balance sheet.

According to the U.S. Treasury’s website, real interest rates cross into the positive only after going 10 years out on the curve. In that light, further reducing long-term borrowing costs may encourage companies to invest in longer-term, capital-intensive projects that were previously deemed too risky. Corporations are sitting on a lot of cash, and lower long-term yields may be just the solution to force them to use it.

Let’s not forget that refinancing at lower mortgage rates will put money directly into the pockets of consumers. A nice boon in time for holiday shopping.

It’s also possible that Operation Twist will be ineffective, and the Fed has spooked the markets with its doom-and-gloom forecast.

But I’m optimistic that policymakers at the Federal Open Market Committee aren’t asleep at the switch, and are trying to guide the U.S. economy out of unprecedented market conditions. If I’m wrong, and they’re simply fumbling in the dark, we’re in for a world of hurt.

 

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