Is Operation Twist in the Fed’s future?

Fed Chairman Jerome Powell is speaking today on the US economy at 12:00pm EST at the WSJ Jobs Summit.  The Fed has a dual mandate to keep inflation between its target of 2% to 3% and to maximize employment.  Inflation expectations have been rising over the last month given expectations of a strong post-pandemic recovery, while job growth is low.  The rise in inflation expectations has been giving a boost to longer-term bond yields, so the markets say.  However, Jerome Powell, many on the Federal Reserve Open Market Committee, and other central bank leaders and speakers around the globe have attributed the rise in yields to increased confidence in the recovery process, but there is still a long way to go.  The US Fed has said that the increase in yields is a good thing and that they will let inflation run “hot” for a period of time.  The Fed has also said that they are committed to buying $120 billion of bonds a month: $80 billion worth of Treasury bonds and $40 billion of mortgage backed securities.  They also believe this will keep rates low for some time while employment recovers. However, given the current yields in bonds, the market seems to believe that the Fed will need to taper sooner. The chart below shows the pickup in the pace of rising 10-year Treasury yields since February 1^st.

Source: Tradingview, FOREX.com

The Fed is now faced with a conundrum.  To keep rates low, they can increase the amount of bond purchases.  The markets would therefore call out the Fed and force them to adjust.  How can the Fed do this and save face? Enter Operation Twist! Operation Twist (as it has been called) is when the Fed sells (or stops buying) short-dated maturity bonds and buys long-dated bonds.  In theory, this would lower yields on long-term bonds while maintaining the ultra-low rates on the short-term bonds.  The Fed used this technique in 2011 to bring the economy out of a recession. The chart below shows the current rate of change between the 10-year Treasury yields and the 2-year Treasury yields.  The Fed wants to bring this rate of change lower.

Source: Tradingview, FOREX.com

This is the last time Powell is set to speak before the FOMC meeting on March 15-16.  During that meeting, Fed members are also expected to give their outlook to growth and inflation.  As that meeting is only 2 weeks away, Powell is unlikely to adopt Operation Twist during today’s speech.  However, markets will be monitoring his speech very closely for any hints as to what the Fed may do next.  If the markets get a sense of changes by the Fed (i.e. Operation Twist), watch for yields and the US Dollar to move lower, while stocks resume their move higher.

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