Personal Finance: Fed plan could bring depositors slight gain

Personal Finance: Fed plan could bring depositors slight gain

September 7th, 2011 by By Chris Hopkins in Business Around the Region

Dust off your dancing shoes and get ready for the next act of desperation from the Federal Reserve: Operation Twist. In response to last week's decidedly dismal employment report, monetary policymakers appear to be considering an effort to flatten or "twist" the Treasury bond yield curve in an effort to stimulate economic activity and promote job creation.

While the ultimate effect on employment is likely to be negligible, the action may benefit savers who have been penalized by near-zero interest rates on their safe investments.

The relationship among government bonds of varying maturities is referred to as the "term structure of interest rates." Under normal circumstances, bonds of similar risk but longer times to maturity generally carry higher interest rates than comparable bonds of short duration.

This is, of course, to be expected, considering the greater time commitment, the increased risk of rising interest rates over the life of the longer life of the bonds, and the poten-

tial for higher inflation.

Investors experience this effect routinely when shopping for CDs, expecting higher rates in exchange for longer maturities.

The details

A graph of U.S. Treasury bond yields for various maturities is referred to as the Treasury yield curve. This graph conveys the relative premium, or "spread," in yield for longer-dated bonds versus short-term bonds. Currently the curve is relatively steep; one-year bonds yield 0.10 percent while the 10-year yield is 2.1 percent and the 30-year pays 3.5 percent.

Enter Operation Twist. Taking a page from the Kennedy administration playbook, the Fed is reportedly studying the efficaciousness of taking action to flatten the yield curve.

Last attempted in 1961, the idea is to sell off some of the Fed's inventory of short-term government bonds and buy up an equal amount of longer-term paper (sell two-year and buy 10-year bonds). In theory, the action would drive longer rates down (supporting lower home mortgage rates and encouraging business investment) while allowing short-term rates to rise.

The impact of the first Operation Twist 50 years ago was minimal, but the scope was much smaller than any effort being contemplated today.

If the Fed sold off all of its holdings with 2013 maturities, they would be able to purchase $200 billion to $300 billion in 10-year bonds, an order of magnitude greater than the 1960s version.

In any event, monetary policy is not an effective tool for stimulating an economy that is undergoing a credit contraction, and Ben Bernanke is no Chubby Checker, so the impact on job creation will be minimal.

Small business hiring and home construction are not still stuck in neutral because interest rates are too high.

Small help for savers

However, for the conservative saver who has been lamenting the lack of return available to safer alternatives, some help may be on the way.

One implicit objective of the current zero-rate policy has been to drive risk-averse investors into riskier assets in order to support stock price appreciation.

If Operation Twist is launched, short-term returns on CDs and money market funds may begin to look more attractive.

At least a little.

Christopher A. Hopkins, CFA, is vice president of investments at Barnett & Co. Inc. in Chattanooga.