Market expects Operation Twist in September

NEW YORK: U.S. government bond investors see Federal Reserve action to boost the flagging economy as practically a done deal after the dismal jobs report on Friday, Sept 2.

Market participants now think the Fed will likely announce a plan to sell short-dated Treasury debt and use the proceeds to buy long bonds after its meeting later this month.

Government data showing the U.S. economy failed to create new jobs last month made the Fed's move, about which there had been much speculation over the past two weeks, seem all but inevitable.

Known to some in financial markets as "Operation Twist," the plan's goal would be to flatten the yield curve, lower long-term interest rates and stimulate the economy.

The Treasury market appeared to price in greater likelihood of this after the jobs report, with U.S. 30-year bonds surging 3 points in price.

"Following today's worse-than-expected jobs report, we now look for the Federal Open Market Committee to announce a lengthening of the average maturity of the Fed's balance sheet at the September 20-21 meeting," Jan Hatzius, chief U.S. economist at Goldman Sachs in New York, wrote in a note to clients.

Some analysts said even without the dismal jobs data the Fed's move would have been inevitable.

"We thought they were going to do it in August," said Ira Jersey, interest-rate strategist at Credit Suisse in New York." "But I guess with some of the operational issues it raises they wanted to wait."

HOW IT WORKS

Operation Twist would take some fancy footwork, Jersey said, with the New York Fed likely having to hold two auctions in a single day.

The Fed would first sell shorter-dated securities and would then hold a second auction to buy bonds of longer maturities from primary dealers. Both auctions would settle the following day.

While it would lower rates at the back end of the yield curve, Operation Twist could also nudge front-end rates higher, possibly to the benefit of money market funds scrambling for ultra-safe securities with a yield above zero.

"The way we looked at it, it looks like they could sell something like $265 billion -- everything they hold through June 30, 2013 -- and that could be absorbed with very modest rate movement," said Thomas Simons, money market economist at Jefferies & Co in New York.

"It might push rates a few basis points higher" in shorter-dated Treasuries, he added.

Goldman's Hatzius said such an operation would ultimately remove so much longer-dated debt from the market, its effect would be almost as big as the Fed's last major easing program.

Referred to by many as QE2, the Fed bought $600 billion in Treasuries. Quantitative easing has been considered an effective monetary policy tool when interest rates are near zero.

"This type of operation would be the equivalent of 80-90 percent of QE2 in terms of duration risk removed from the market," Hatzius said. - Reuters