- Understanding "Operation Twist"

I want to explain something about operation twist, but first I have to explain some terminology.

We on the institutional side of the financial markets tend to talk and think about finance differently than the people who deal with retail investors. We have our own language of sorts. And since the people we talk to know about as much as we do, we end up using terminology that amounts to abbreviations that retail people don't typically recognize. If you pay attention to the financial centric posts on this blog you might see Ikaika and I doing it a bit.

Finance itself has a lot of words which mean something in that context that they don't to the general population. And that leaves us saying things to each other which sound like nonsense to others. If I were to discuss a "forward - forward" for instance, some readers might think I was stuttering. Or if I talk about an "implied option" or some other "implied derivative", it all sounds like I'm not talking about an actual thing", but I very much am. And one other word which is very commonly misunderstood is the way we use the term "duration".

Duration is a way of referring to interest rates and the dollars received from a bond or a portfolio of bonds. We use the term to help describe the sensitivity of those bonds to a change in interest rate (actually the interest rate curve), which in turn helps us to manage the risks associated with the portfolio. In a broad and simplified sense, to have a higher 'duration' is to have a greater sensitivity to interest rates. So it would be sort of correct to say that Duration describes the 'substance' of a bond portfolio.

So here's the thing about operation twist that I don't think retail investors understand. If the Fed buys long term debt and issues only newly printed dollars, it's called "monetizing debt". People understand that and don't care for it. But suppose instead the Fed buys long term debt and then issues 3 month debt instead of dollars. Is that monetizing the debt? The answer is, mostly yes. The "cash" has a duration of zero. Rates can change in any way and it's still going to be worth a dollar. Short term debt, in this environment has a duration of almost zero. So the Fed is almost doing the same thing, except they're giving it enough political cover so the Maxine Waters' of the world and her like in Congress don't see it as a political issue.

Think of it this way, suppose the Fed bought Ten Year Treasuries and issued 1 day debt in an equal amount instead of the three month debt it's using in operation twist. Then tomorrow that newly issued debt would be converted to "cash". Most people get that this would be "monetization". Suppose then they kept rolling it over in greater and greater amounts so it doesn't show up as a difference on the balance sheet. How different is that? In terms of duration, it isn't different at all. It's exactly the same thing. But for some reason the retail market doesn't see that.

Now some caveats. I'm not saying that retail investors are stupid, they aren't. Their knowledge is just more diverse than ours in the institutional business, so the abbreviation of principles isn't as effective. I'm also not saying that this extremely simplified example I'm offering tells the whole story - it doesn't. But I do think it conveys the general principle as it's understood by the institutional side of the business.

Operation twist may seem politically like all is well because the Fed "isn't expanding its balance sheet". But in fact the duration of the Fed's portfolio is changing dramatically, and the duration available to the open market is changing dramatically too. It's monetization (or QE) by another name, covered in a way to slip it past congress and the idiot financial press. And to the disbelief of many of us on the institutional side, everyone seems to be falling for it. It's so obvious to us that it almost doesn't seem worth mentioning. But the press, the public, and especially the poltiicans, all seem to have been fooled.