Thursday, May 17, 2012

Fed's operation twist is distorting the treasury market

Fed's Operation Twist is starting to introduce some "unintended consequences" into the market. The 10-year treasury yield has collapsed on the back of Eurozone's latest troubles. One would expect the two-year note to trade with a lower yield as well. But in fact the 2-year yield has been moving up. The Fed wanted to lower long-term rates without impacting shorter term rates -  and that is proving difficult.

2yr vs 10yr treasury yields

Even today, in the face of new fears about Spain (with a potential run on the banks there), the two-year treasury yield is still moving higher.

Today's treasury yield move by tenor

The question now is whether these yields will reverse direction once Operation Twist ends this summer. Given the global economic backdrop, the Fed will likely not want to end the program, but the central bank will soon run out of two-year treasuries to sell. The next step will be sterilized purchases.

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