Treasury Curve Dysfunction Ignites Talk of Federal Reserve Twist

(Bloomberg) -- Turmoil in Treasuries that has sent longer-dated yields soaring is stoking talk that the Federal Reserve might look to revive Operation Twist in order to reassert stronger control over interest rates at both ends of the yield curve.

Rising expectations about inflation and an unraveling of market positions helped send bond yields surging last week, with the benchmark 10-year rate spiking above 1.6% for the first time in around 12 months. The surge has brought with it sloppy auctions, worsening liquidity and a wider difference between bid and offer prices. At the same time, there is also concern about rates at the front end potentially going too low, with funding markets hovering around zero amid an abundance of dollars that’s being fueled by monetary policy, fiscal measures and changing bill-supply dynamics.

The phenomena at both ends of the curve represent possible threats to the Fed’s control of policy, and that has observers casting about for potential next steps by central bank officials. Chairman Jerome Powell and his colleagues have an array of tools at their disposal -- for example, a tweak to the interest on excess reserves rate to help control the front end. But a number of analysts have been recommending the revival of a so-called twist maneuver, which would see it simultaneously increasing its holdings of longer-term debt and reducing its ownership of Treasury bills.

“The Fed is simultaneously losing control of both the U.S. front end and back end rates curves for different reasons,” Bank of America strategists Mark Cabana, Meghan Swiber and Olivia Lima wrote in a note to clients. The implementation of a twist “kills 3 birds with one stone.”

Their argument is that it would help lift rates at the short-end and stabilize yields at the long end, but do so in a reserve neutral fashion that lessens the pressure on banks to hold more capital under the supplementary leverage ratio. To address market functioning issues, the Fed could initially sell $80 billion a month of bills and concentrating monthly purchases in Treasuries maturing in 4 1/2 years or more, they wrote.

Credit Suisse Group AG strategist Zoltan Pozsar has also recommended the Fed embark on a twist to stabilize yields in addition to offering greater clarity on the supplementary leverage ratio, with uncertainty around that also adding fuel to recent gyrations.

The last time the Fed utilized a twist was in 2011, when the central bank decided to sell shorter-dated Treasuries in favor of longer-dated holdings to help spur the recovery by lowering long-term borrowing costs.

Richmond Fed President Thomas Barkin said in an interview on Bloomberg TV Monday that while the central bank has control of the short end, the long end of the yield curve is a natural reaction to the outlook.

Jefferies economists Aneta Markowska and Thomas Simons said for twist to be a “viable option,” the Fed would have to first focus on stabilizing the front end of the curve, emphasizing the “long road to unemployment and sustained 2% inflation.” They don’t expect the Fed to push back against the back of the curve.

And while Bank of America is busy talking about the need for a twist, they say it might be some time before the Fed also comes to that conclusion, noting that policy makers likely need to see signs of a further deterioration in liquidity and market conditions.

“There will likely be more market pain before the Fed is forced to act,” they wrote.

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