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Operation Twist Already Lowering Rates

Timothy Strauts

Tim Strauts: I'm Tim Strauts at the Morningstar ETF Invest Conference. With me today is Steve Laipply, senior fixed-income strategist from BlackRock iShares.

Thanks for being here Steve.

Steve Laipply: Thanks for having me.

Strauts: Federal Reserve chairman Ben Bernanke recently announced what people are calling Operation Twist, the Federal Reserve's idea of selling its short-term bonds and buying longer-dated securities. What kind of affect this is going to have in the fixed-income market?

Laipply: Yeah, I think the goal here what the Fed wanted to do was to try to ease financial conditions without monetizing additional debts. So, one of the criticisms that the Fed faced earlier for the second round of quantitative easing was that it effectively monetized debt. So, what the Fed wanted to do is essentially extend the maturity profile of their balance sheet.

So, by doing so, what they're going to do is sell shorter-term holdings and buy longer-term holdings. I think the amount they targeted was around $400 billion. So, it looks they're going to split that about a third in sort of 6- to 8-year bonds, a third in kind of 8- to 10-year holdings, and then a third in the back end of sort of 20- to 30-year holdings.

The overall goal is to drive down longer-term rates presumably to help drive down mortgage-refinancing rates and lending rates across different credit products to help ease financial conditions for consumers.

Strauts: Now, it looks like the market was somewhat expecting this. It looked like the 10-year Treasury moved down a little bit, but really for the 30-year bonds, where we saw most of the action, we weren't quite expecting so much of the assets to go toward the long-end of the curve.

Laipply: Yeah, that's correct. Some of the estimates I saw from dealers were in the sort of $200 million to $300 million range. I think a lot of those estimates were more heavily weighted toward kind of the 10-year part of the curve. I do think that they surprised on a couple of accounts. One, by the absolute size. So, it's kind of moving from that $200 million to $300 million, and then out to $400 million, and then full third of it is toward the back-end of the curve. So, I think the market wasn't necessarily anticipating that, and we could see yields have dropped pretty sharply in the long end of the curve to reflect that.

Strauts: Now the 10-year Treasury as of right now is about 1.75%, which is an all-time low, which for an investor in fixed income might not be good if you're looking to add money to the space. What does this mean for a fixed-income investor with yields this low?

Laipply: Yeah, there are two components. It's reflecting break-even inflation expectations, what the market is expecting inflation to be during the next 10 years, so roughly 1.75%. So, it's right about the actual yield. Real yields, implied real yields or absolute real yields, are roughly zero for 10-year Treasuries. So, essentially the entire nominal yield right now is based upon inflation expectations.

Now, it's been this way for a while. We've seen a steady drop in real yields across the curve. The short end of the curve is very negative. That's on purpose. That was part of what QE2 is designed to do: increase expectations for inflation on the front end and lower real yields to ease financial conditions. That's working its way out the curve.

It will be interesting to see how this plays out in the back end of the curve. Now, just looking from the announcement yesterday to today, we've actually seen break-even inflation fall across the curve, most notably sort of in the 10-year space. So, it's going to be interesting to see how this plays over time.

Another indicator that they look at is five-year inflation, so five-year inflation five years forward. Interestingly, that's also come down. So, I think this is largely a result of the market being more alarmed by some of the language around, what they think of economic conditions and the downside risks to that, and perhaps overreacting to that with a view that, "Is the Fed concerned? Should we be more concerned?" et cetera. So, I think that's kind of what's playing out. That's being exacerbated further by an overall view today. I think the global growth expectations might be coming down, as well.