On Wednesday, the Fed left the world markets with a lollipop instead of a box of chocolates. The market was hoping for another round of quantitative easing. This is a way of injecting money into the market, because the Fed then buys either Treasury bonds or mortgage bonds. These bonds were already in the market.
Think about “supply and demand.” When demand increases, the price will normally increase. In the case of bonds, when prices increase, that means the yield goes down. For example, if a bond sells for a $1,000 and pays a 2% interest rate, the bond owner receives $20.00 in interest annually. However, if that bond rises in price to $1,010, the annual interest income remains the same, which means the yield has dropped to 1.98%. ($20/$1,010)
When the Fed says they will buy more bonds, the demand for bonds goes up, which means the yield goes down. Lower interest rates are expected to help the economy (although it may cause commodity prices to rise).
What the Fed announced on Wednesday was that they would continue “Operation Twist” until year-end, which is a watered-down version of quantitative easing. Normally, bonds that mature early pay lower interest rates than bonds that tie up your money for a long time. If you graph the relationship between interest rates and bond maturities, it is called the “yield curve” and would look something like this:
Now, under “Operation Twist,” the Fed sells short-term maturities and buys long-term maturities. That increases supply of short-term bonds, driving down their price, and driving up their yield. That also increases demand for long-term bonds, driving up their price and driving down their yield. The end result is raising short-term rates while lowering long-term rates. In other words, the yield curve becomes flatter.
This encourages people to buy homes and businesses to refinance their short-term debt into long-term debt, making them even stronger. But, is it effective? Yes, businesses are aggressively refinancing their short-term debt into cheap long-term debt. No, because mortgages are so hard to qualify for, regardless of the interest rate.
There is a certain irony in all this to economists, who were taught that a flat yield curve is a strong indicator of an impending recession. Now, the nation’s economists are intentionally causing the yield curve to flatten.
Bottom Line: Operation Twist is a lollipop, better than nothing, but not as good as a box of chocolates . . . or quantitative easing.