Diary of a Financier

Null Hypothesis: Operation Twist, Another Underdog?

In Economics on Mon 17 Oct 2011 at 22:59

Fact of the matter is, someone is on the other end of every trade I make, and if he wins, I lose. So, I always have to try and disprove my own thesis, see his thesis. Is he part of consensus, the herd, or does he see something nobody else (including I) noticed? Kind of like hypothesis testing.

S&P 500 Futures (SP/) tried to make a straight run for 1250 last night. It got me thinking about that guy on the other end of my trades. I gasped when SP topped out at 1230 around 4:30am. I went back to sleep frustrated, thinking, ‘I know I hadn’t missed anything in my fractals. The charts so rarely lie when the stars are so aligned. Actually, maybe that’s just it, maybe it was time to buy, after all, there was blood in the streets. It happens. Remember emotional equilibrium, the big picture.’

I though I had been beaten in this latest, psychological battle. I was happy to admit that to my Diary (and my business partner) this morning, after scanning all fractals to find if I had missed something, to see if a move was underway. I was amazed Futures surpassed that 1220 resistance with such gusto last night.

I awoke around 6am to behold an SP slide. The slide persisted through the open, ending the day more like a cascade come the close. I just heard one of the FastMoney postgame traders on CNBC say, “This market is trading in a range, so I’m amazed how everyone keeps getting impaled at every turn.” Judging by the paltry E-mini (ES/) Sunday-Monday overnight volume, a few small position traders were trying to catch a breakout atop that 1220 print… “impaled.”

I’m winning, I suppose. (I’m not sure if anyone’s really winning when the market reels.) As very few investors ever realize the intra-session meanderings of futures, cash markets ultimately provided the verdict throughout the NYSE trading day. I want to focus on what was going through my mind last night, one of my null hypotheses: What if I underestimated Operation Twist? What if the market’s initial repudiation of the program was just like its reaction to Twist’s predecessors (TARP, TALF, QEs)? I think it’s a cogent argument to evaluate, certainly one arrow in the quiver of my adversaries.


My stance remains:

My guide is the 2008 analogue still, and hence the downside trigger I’m awaiting is illustrated in the 2008 chart: simultaneously overbought daily & weekly fractals with resistance met around the 200DMA (~1250)…

If I have to deliver a wormhole, the coming days-weeks will see SPX knock resistance at 1215-1220, oscillate back down to 1140, then snap back on an assault of 1250

I’m still doggedly focused on the developing big picture–a second opportunity to buy equities at generational discounts [SPX 1045] on the other side of the European fallout. That is priority #1. In the meantime, I’m quite feeling the rhythm of this market and looking to capitalize modestly upon a short-term pullback.

As last week ushered equity markets back to the top of their range, I took some time to study the original Operation Twist from 1961. I actually dug up a 2002 speech by Paul Volcker regarding the “unconventional policy program”:

In the 1960s, I moved from the Federal Reserve to the Treasury Department. At the time, we faced what was perceived as a dilemma for debt management and monetary policy. We had a trade surplus, but the balance-of-payments deficit probably ran as much as $2 billion or $3 billion a year. This was a matter of some considerable concern around the world, since it raised questions about whether our low interest rates and capital outflow would determine the role of the dollar in the world economy. [This was a Bretton Woods I environment that fixed exchange rates to a USD backed by gold.]

Bob Roosa had preceded me in moving from the Federal Reserve to become Under Secretary of the Treasury for Monetary Affairs. In response to this situation, he helped develop what was called Operation Twist: the Treasury would retire long-term securities and issue short-term securities based on the theory that it was the short-term rate that was relevant for international capital flows, while long-term rates were more relevant for the domestic economy, mainly because they affected the mortgage rate.

Well, to the extent that Operation Twist worked at all… depended on some degree of market imperfection. And I think it became apparent fairly quickly that the market imperfection was not as great as had been assumed.

Mr. Volcker goes on to describe a real “imperfection imposed on the market, and it was not ineffective at all… Regulation Q, which placed a ceiling on commercial bank interest rates.” This offers an incredibly relevant pro forma evaluation of the 1960s Operation Twist, suggesting that the Twist had only worked if it generated “market imperfections” (i.e. manipulations of otherwise market-determined prices). That leaves me with a big question: are today’s rates manipulated? Simply put, yes they are, since they’ve been guided (gapped) to these levels by monetary policy and QEs; yet at this point, the Twist itself has accomplished nothing towards such “market imperfections” in Treasuries, MBS, or other assets for that matter.

Believe it or not, the Federal Reserve Bank of San Francisco (FRBSF) ran a report in April 2011 that evaluated the quantitative effect of the 1960’s Twist, concluding:

An analysis finds that four of six potentially market-moving Operation Twist announcements had statistically significant effects and that the program cumulatively caused a significant but moderate 0.15 percentage point reduction in longer-term Treasury yields…

Subsequent research (Swanson 2011) found that the spillovers from Operation Twist to agency and corporate bond yields were also statistically significant but smaller, amounting to about 0.13 percentage point (13 basis points) for agency bonds and 0.02 to 0.04 percentage point (2 to 4 basis points) for corporate bonds. Thus, the effects of Operation Twist appear to diminish as one moves away from Treasury securities and toward private credit markets.

The above passages suggests the Twist will not materially affect the riskier assets above Treasuries on Exter’s Pyramid. Since the Fed’s balance sheet will not be expanding at the rate of continued systemic asset deflation, I’m willing to add that today’s Twist will face the same fate in terms of encouraging risk assets–even though the Twist is almost 60% larger than 1961’s (as measured relative to GDP).

I know, this has all just turned into a giant refutation of my current adversaries’ bull case for SPX. I butted-in before they even spoke-up. They can simply point to the Dow’s (DJIA) performance during the original Twist as a guide:

DJIA (1961)- Operation Twist

The aforementioned FRBSF piece would argue that the DJIA performance throughout the 1961 Twist was a trajectory already established before the Fed program trickled down. I’ll tell you, I set out on this entry to substantiate a bull case. After every paragraph of my drafts, I found academic and empirical evidence to retract such arguments.




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