Fed moves from the twist to the hammer

As recently announced by the Federal Reserve Bank, it will begin outright purchases of U.S. Treasury notes and bonds in 2013. With the expiration of Operation Twist coming upon us, the Fed determined additional quantitative easing is necessary to assist the elusive U.S. economic recovery.

In the Twist strategy, the Fed sold shorter-term U.S. Treasury securities and purchased longer-term U.S. Treasury securities. With the 10-year U.S. Treasury note yielding approximately 1.7 percent and the 30-year U.S. Treasury bond yielding about 2.9 percent, the increased purchases of these longer-maturity securities can only result in these interest rates falling so far. In the Fed’s recent announcement, it indicated monthly purchases of longer-term U.S. Treasury securities will total $45 billion.

Outright purchases of longer-term securities are intended to push, or hammer, interest rates down even further. Lower long-term interest rates will generally benefit individuals and companies seeking to lock in long-term borrowing costs. At the same time, individuals and companies seeking to invest in yield-oriented vehicles will garner lower interest rates on their new investments. Borrowers benefit while investors are penalized from these historically ultra-low interest rates.

Along with the recently announced outright purchases of longer-term U.S. Treasury securities, the Fed will continue its monthly purchases of approximately $40 billion of residential mortgage-backed securities. One significant objective of these monthly $40 billion purchases is to decrease the borrowing costs for those seeking new residential mortgages.

Purchasing these mortgage-backed securities will likely result in a decrease of the incremental yield, or credit spread, on residential mortgages above the underlying interest rate. As the publicly-available supply of mortgage-backed securities decreases and assuming a relatively constant demand from investors for these securities, the Fed’s purchases are intended to further depress longer-term interest rates.

One of the key messages the Fed is communicating through these actions is that the U.S. economy is expected to continue to struggle for some time. With short-term interest rates already very close to 0, the Fed’s actions are increasingly focused on hammering down longer-term interest rates as a means to spur domestic economic growth.

Kirby Brown is the CEO of Beneficial Financial Group in Salt Lake City.