Sterilization - QE 3 With Another 'Twist'

Neena Mishra, CFA

According to a Wall Street Journal report, the Federal Reserve is considering a new bond purchase plan when the “Operation Twist” ends in June this year. The plan would be to buy bonds but ‘sterilize’ those purchases to avoid any inflation threat.

Sterilization would be conducted by reverse repos. Repos (repurchase agreements) are transactions used for short-term funding. They typically involve the sale of U.S. government securities in exchange for cash, whereas the securities are held as collateral for the loan. Reverse repos are basically purchase of securities with an agreement to sell them at a future date. By conducting reverse repos, the Fed temporarily drains cash from the banking system. (Read-Follow Buffett With These Developed Market Bond ETFs)

The Fed has carried out two rounds of quantitative easing since 2008, and also conducted ‘Operation Twist’. Operation Twist involves sale of short-dated Treasuries and using those proceeds to buy long-dated Treasuries.

After the FOMC meeting in January, the Fed had announced that it expects to hold rates at exceptionally low levels at least through late 2014. The minutes of the meeting showed that while the committee members were divided over the need and timing of additional asset purchases, most of them remained open to the idea if the economic outlook deteriorated. (Read-ProShares Debuts Two Leveraged Treasury-TIPS Spread ETFs)

As of now, the economy is showing sustained strength. The European debt situation appears to be stabilizing and so another round of QE may not be needed at all. But by keeping the QE talks alive, Fed wants to make it clear that QE3 is still not off the table. The Fed may introduce QE3 if the job situation does not improve substantially, particularly since inflation concerns remain subdued as of now, despite recent risk in oil prices.

Treasuries have remained in a tight range in the recent months as on one hand, the improvement in economic data encourages the investors to seek riskier assets and on the other hand since Europe is still not out of the woods, emerging economies are struggling to maintain their growth rates and the recovery in the US is weak; there are still buyers for the Treasuries, perceived as safe haven assets.

Treasuries which have also drawn support from expectation for another round of additional bond may weaken on receding expectations for QE3 or any diluted version of QE. The markets saw a brief spike in the yields on the news of sterilized QE. Today’s positive job report should further reduce the chances of another round of easing by the Fed in the coming months. After the report, the benchmark 10-year Treasury note was trading slightly lower this morning to yield 2.04%, up from 2.02% yesterday.

For the investors betting against the treasuries, there is a wide range of choices available. The popular ones are ProShares Short 20+ Year Treasury (TBF), iPath US Treasury 10 Yr Bear ETN (DTYS),  iPath U.S. Treasury 2-Year Bear ETN (DTUS) and Direxion Daily 7-10 Year Treasury Bear 1x Shares (TYNS). (Read- Three Bond ETFs For A Fixed Income Bear Market)

We may however warn such investors that they should not expect any sharp turnaround in the yields anytime soon since the global economic situation remains volatile and the Fed remains committed to keep the rates low.

Read the analyst report on TBF

Read the analyst report on DTYS

Read the analyst report on DTUS

Read the analyst report on TYNS

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