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Operation twist is the media name for the Federal Reserve’s latest round of asset buying.

According to the Fed, they will be buying longer term (mostly 10 year) treasuries and selling shorter term bonds.  In addition, they will be reinvesting dividends from their asset backed securities purchases (from QE1) into additional mortgage backed securities.

The effects, although somewhat muted, will be noticeable.  This is the Fed throwing in the kitchen sink.  Long term interest rates will come down some, although not a huge amount.  If the 10-year bond falls closer to 1%, that will be a sign the economy has tipped back to recession.  Even with a low-growth scenario, Operation Twist is perhaps enough to bring fixed mortgage rates below 4% and create another round of refinancing.

This is both good and bad for banks.  The good is that a lot of questionable mortgages will get refinanced into more stable loans.  The bad is that it makes banks less profitable.

I don’t see the sales of short term bonds having much effect, as demand for short term bonds is already high and the Fed controls interest rates of that duration anyway.

The purchases of asset backed securities will also help banks clear up room to provide more lending.  Whether or not they will have a lot of profitable opportunities to do so is another question.

Finally, it must be noted that there is some deflationary effect from this.  As bond interest rates go down, there is less interest income going to the private sector.  This hurts savers who are spending out of their retirement incomes.  Interest rates are always a two-way street.  Yes, declining interest rates create demand for credit.  But it also dampens overall aggregate demand because there is less interest income in the economy.

Overall, risks remain high.  The large deficit continues to work its magic by allowing households to reduce debt, but demand remains weak and unemployment tragically high.


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