Operation Twist, Or Is It the Logic That’s Twisted?

One can’t force risk taking

Bill Gross wrote an opinion piece in the FINANCIAL TIMES entitled “‘Helicopter Ben’ Risks Destroying Credit Creation.” In it, he discussed the risks inherent in an “operation twist.” Bloomberg summarized the conclusion: “If the Fed seeks to drive down longer-maturity yields, as some are anticipating, then the central bank may ‘destroy leverage and credit creation in the process’.” Basically, Bill Gross argues that a “barbell” approach is a logical response by investors. That should sound familiar to readers of the Hedged Economist. The last posting on this blog, “Speak Softly But Carry a Big Stick, Dr. Bernanke,” pointed out that the portfolio adjustment is only part of the story.

Pursuing a barbell approach is probably important among money managers, but for individual investors, the major impact of an operation twist will be that it introduces more uncertainty. The uncertainty is real. Many individuals sense that we’re approaching a situation described in that posting: “Under that scenario, the net result would be an optimum portfolio composed of just the safe, liquid asset. In the common vernacular, the market participants conclude that not losing is a higher return than any potential positive return. Heard that lately? If not, get the beans out of your ears.” Operation twist contributes to the very problem a central bank can’t easily solve (i.e., a liquidity trap).

The Fed needs to think about investor reactions, not economic theory. Granted, in a backhanded way, economic theory explains the phenomena, but few students of economics think in terms of what actions or conditions invalidate a conclusion. Yet, as pointed out “…the adjustment process necessitates a period where covariances will break down. Why people assume that the covariance matrix is stable escapes this observer. Stability of the covariance matrix seems like a particularly silly assumption when policies that will destabilize it are the current rage.” Operation twist weakens, or perhaps undermines, the assumptions one has to make in order for it to be justified.

The Fed has other less risky options.