Let's Do The Twist, Like We Did In The '60's

Last night, in the Wall Street Journal, journalist Jon Hilsenrath essentially told us what we already know.The Federal Reserve is going to act with additional easing.Hilsenrath has long been the preferred mouthpiece of the Bernanke Fed, and to have him write an article like this is not startling at all, considering many have been calling for a third round of quantitative easing for some time now. In fact, back in June, Bill Gross tweeted that he expected the Federal Reserve to mention something about a third round of quantitative easing at its Jackson Hole, Wy. meeting in August. Hilsenrath also talked about lowering interest on excess reserves, and talking more about keeping rates low for an extended period of time, but both of those are not exemplary, and would probably have little to no effect. The interest on excess reserves could potentially cause problems in money market funds, and the language would have little to no effect right now.During Bernanke's speech, there were tiny hints at a third round of quantitative easing, but nothing like what he said in August 2010. The only major move Bernanke said was that the Federal Open Market Committee (FOMC) would be extending its September meeting to two days to allow for more discussion. Many took that as a potential sign for QE3. Essentially, they see Bernanke as Superman, except he is acting more like Clark Kent in this situation. Since there is so much political pressure on the Fed to not expand its balance sheet, it will more than likely do what is known as Operation Twist, which was first enacted under the Kennedy Administration on February 2, 1961. Operation Twist involves the buying of longer-dated securities (U.S. Treasuries) financed by selling shorter term securities. Some, including UBS' Art Cashin, have said that Operation Twist is already a failure. Courtesy of ZeroHedge, here are some highlights of Cashins' note this morning concerning Operation Twist:"Enter “Operation Twist” – a plan once used in the early 1960's where the Fed purchases 10-year Treasury Notes, which would – in theory – cause mortgage rates to drop, and therefore, cause an upswing in housing activity. And better still, the funds to purchase these would come for the Fed selling its holdings of shorter term maturities, so there would not be a need for additional money. Sounds interesting, but there are many flaws. If the plan is successful, short term yields would rise and longer term yields would fall, creating a flatter yield curve. The banking industry would see profits erode, and many businesses would see short term borrowing costs rise. But the real problem with “Operation Twist” is, like other plans we have seen in recent years, it could still fail even if it works. Mortgage rates are already so low…really historically, ridiculously low. So why would making rates even lower solve the economy's ills? It won't, and it will not fix the housing market either. The problem is not that rates are too high, it is that individuals can't take advantage of the low rates that are already on the market. Most people want to refinance but can't. In many cases it's because they owe more on their home than the acceptable appraised value. This actually causes many of them to become frustrated and to stop paying their mortgage, which exacerbates the problem. A better idea would be for the Fed to step in and take a second position so that individuals can refinance and lower their payments."Since banks borrow short and lend long, crushing the yield curve and inverting it could potentially destroy the banks profitability, and cause another TARP-like program. We are seeing problems of confidence in the banks, particularly Bank of America (NYSE: BAC). Things have gotten so bad, Warren Buffett had to step in and provide Bank of America with $5 billion in capital. If the yield curve gets even more screwy because of Operation Twist, not even Buffett himself has enough dry powder to save the banks.With every bank, (particularly Goldman Sachs) wanting a third round of quantitative easing, the Fed has boxed itself into a corner, and must provide a third round of stimulus. Recent comments by Chicago Federal ReservePresident Charles Evans have only strengthened the signal that we will see more easing.Whether "OT2" as some are calling it, works the way the Fed hopes, remains to be seen. It did not work in the 1960's, and there is little reason to think it will work now. The U.S. dollar will likely get weaker as the result of additional Fed easing, and the demand for U.S. Treasuries will continue to remain robust. With mortgage rates at record lows, the chances of additional monetary stimulus perking up the U.S. economy are slim at best.It does not matter though what we think, as Bernanke and the rest of the Fed are hellbent on doing whatever they can to try.Since that's the case, we might as well get our dancing shoes on, and twist again.ACTION ITEMS:

Bullish:
Traders who believe that Operation Twist will be mentioned sooner rather than later might want to consider the following trades:

• We may see equities jump on the expectations of more easing. Tech names like Microsoft (NASDAQ: MSFT), Apple (NASDAQ: AAPL) and EMC (NYSE: EMC) have been fairly strong recently.

• Also consider commodity names, like Mosaic (NYSE: MOS), Potash (NYSE: POT), and Freeport McMoran (NYSE: FCX).

Bearish:
Traders who believe that Operation Twist will not work may consider alternate positions:

• OT2 could crush the banks as mentioned above. Consider shorting Bank of America, J.P. Morgan (NYSE: JPM) and Citigroup (NYSE: C) on the back of this announcement.
  
  

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