The limits to the economic stimulus from ”Operation Twist” were on display on Thursday as the stock market fell and the dollar rose in response to the new $400bn programme from the US Federal Reserve.
The market response is probably not what the Fed wanted or expected in response to its larger-than-expected twist to the yield curve. The Fed will sell $400bn of Treasuries that mature in less than three years and buy the same amount with more than six years to run in an effort to drive down long-term interest rates.
The market moves reflect a crucial problem with all monetary stimulus at the moment: the channels for transmitting lower long-term rates into the economy are not working very well. The ultimate success of the twist depends on whether the financial system can turn it into more and cheaper lending to buy houses and build up businesses.
The biggest beneficiaries of twist will be households with plenty of equity in their home that can refinance their mortgage at a lower rate. Doing so will leave extra cash in their pockets and provide some stimulus to the economy.
The Fed’s decision to start buying some mortgage-backed securities again has led to a sharp fall in interest rates on bonds issued by federal housing agencies such as Fannie Mae. That should spur refinancing because, at today’s low interest rates, banks are reluctant to hold new mortgage loans on their balance sheets, and almost all new lending is going through the agencies.
“The overall debt servicing cost for households is falling because of what the Fed is doing,” says Paul Ashworth, chief US economist at Capital Economics in Toronto. The problem, he points out, is that many households are not in a position to refinance no matter the interest rate.
Data suggest that about a quarter of borrowers have a mortgage worth more than their home and a half do not have the 20 per cent of home equity needed to refinance at a lower rate.
Nor will banks be in any hurry to facilitate refinancing because the twist towards a flatter yield curve with lower long-term interest rates hurts their profits. Banks make most money when there is a big gap between the rate they pay on short-term deposits and the rate they earn on long-term loans.
“It could trigger refinancing of mortgages and lead to companies investing and borrowing,” said Brad Hintz, analyst at Alliance Bernstein, but he noted that “the Fed does not have a long history of successfully managing the shape of yield curve” and profits would be hit because “the best environment for the banks is a steep yield curve”.
Mike Mayo, analyst at CLSA, said: “The Fed’s twist only reinforces the notion that US banks reflect at least a lighter form of what has taken place in Japan. The twist makes a flat yield curve more so and does not necessarily improve confidence since, as we’ve seen, the Fed can increase the supply of money but not the demand for money.”
Christopher Whalen, analyst at Institutional Risk Analytics, noted that the impact on profits was muted because banks’ loan assets had a shorter maturity, a weighted average of three to four years.
But he noted the difficulty there will be in passing low rates through to consumers. “We’re all fixated on the Fed because, in normal times, when they moved this flowed through the housing complex automatically,” he said. But with banks mired in problems “they don’t want to see [borrowers] prepay” existing loans.
For business, while twist may be a boon for large corporations that can lock in cheap funding from capital markets, James Chessen, chief economist of the American Bankers’ Association, said that it may not make much difference for small companies, where the main issue is credit risk.
“A small decrease in interest rates is not going to motivate banks to make small business loans,” he said.
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