Doesn't sound like much, but when employment is stalled at zero net job creation and GDP is anemically bouncing along at 1%, the Fed will try anything.
What is "Operation Twist"?
The Fed's usual modus operandi is to manipulate short-term interest rates by controlling the federal funds rate. Federal funds are borrowed and lent by banks to meet their reserve requirements. Banks can also buy or sell Treasury securities to meet reserve requirements, and so the Fed's manipulating of the fed funds rates affects other rates as well.
In fact, typically rates all along the maturity spectrum - the so-called yield curve are affected.
"Operation Twist" seeks to carry out this impact directly by changing the composition, instead of the size, of the Fed's balance sheet. The plan is to sell shorter maturity Treasury bills and buy longer-term Treasury notes.
The idea is that longer term yields will drop - specifically the rate on 30-year fixed rate mortgages.
Markets anticipate. On Friday, the yield on the 10-year Treasury dropped to below 2% and the yield on the 2-year Treasury note rose 2 basis points. Dealers and others want to position themselves ahead of the Fed's move. This is similar to the carry trade that heats up when the Fed announces it will keep short-term rates low.
Secondly, the Fed will likely find itself loaded up with longer term securities at the lowest point in yields. When the inevitable rise comes, it will have on the books significant underwater positions.
Thirdly, this action, like much the Fed does, ramps up uncertainty. What can I say to a client who asks if now is a good time to take a mortgage? Very likely, by the Fed's manipulating longer term yields, 30-year mortgage yields could be lower in the near future. Market observers believe the policy could be formally announced at the 9/21-22 Federal Open Market Committee meeting. With the uncertainty, it is better to just sit on the sideline and wait.
Finally, this is another slap in the face to those who live off of fixed income. The already anemic rates on such things as 3- and 5-year CDs will decline further. But, hey, it's for the good of the bankers and we all have to sacrifice ( I'm getting ready for Obama's speech on Thursday!).