The coming Treasury Bubble.

I offer you this article that explains why "Operation Twist" is a failure. What the article does not say is the Operation TWist ensures the necessity of QE3, more inflation and a popping of the Treasury bubble.


Fed Unable to Prevent Rout In Long-Term Treasury Market

by: James A. Kostohryz October 12, 2011 , From Seeking Alpha.


Long-term Treasury yields have spiked above the levels that they were at before the Fed announced Operation Twist.

The Fed does not control long-term interest rates. It never has; never will. The Fed cannot even control yields on long-term Treasuries (^TNX, ^TYX), much less long-term borrowing rates to the private sector (LQD, JNK, HYG)

On September 22, 2011, one day after Operation Twist was announced, I warned investors: Nobody is bigger than the bond market; not even the Fed. Consider why:
Operation Twist is not big enough to matter. Operation Twist purports to buy up $40 billion or so of long-term US Treasuries (TLT, IEF) every month. That is relatively small change in a market of this size. The global market for fixed income is over $90 trillion USD. By my reckoning, yearly traded volume is well in excess of $300 quadrillion USD. On a monthly basis Operation Twist would represent about 0.4% of the total global bond market. And it would represent 0.00002% of global bond trading volume during that period.

Quality more important than quantity. Ultimately, long-term inflation expectations and long-term interest rates are a function of confidence in the currency (UUP). The quantity of bonds purchased by the central bank is an ambivalent force. On the one hand, under specific circumstances Fed purchases of long-term Treasury securities could exert downward pressure on the yields of these securities. However, under a different set of circumstances Fed purchases could have the opposite effect. For example, when the Fed purchases long-term Treasury bonds at negative interest rates (T-Notes at 2.0% and inflation currently at 3.8%) it is clearly “debasing” the currency for reasons spelled out in detail here. In this case, the debasement – the difference between the real (inflation-adjusted) NPV of the bond and the face value of the currency issued-- is of a magnitude of about 17%. This sort of operation has consistently served as an inflection point in the evolution of inflationary expectations in the history of inflation crises in various nations. Thus, Fed purchases of long-term Treasury securities in these particular circumstances could actually precipitate a bond market selloff and a spike in yields.

Fed risks “put back.” If investors begin to lose confidence in the US dollar they will begin to “put back” long-term Treasuries to the Fed en masse. There are currently over $15 trillion in US Treasuries with remaining maturities of over six years. Even if a small percentage of holders sell their bonds on the secondary market due to a loss of confidence, the Fed’s $40 billion per month program could become overwhelmed very quickly.

Market could force QE3 or rate cap. If the volume of sales of long-term US Treasuries were to become too intense (or demand for long-term Treasuries were to decline significantly) the Fed would be obligated to expand the asset purchase program in order to hold long-term rates down. This would require the creation of large quantities of money and a further dramatic expansion of the Fed’s balance sheet. This in turn would tend to fuel further skepticism towards the USD (UUP). History suggests that the situation could very quickly spiral out of control.

Conclusion
Ten and thirty year Treasury yields have pierced the levels that they were at prior to the Fed’s announcement of Operation Twist. This has occured despite the fact that there are no significant signs of economic acceleration and the fact that equities (^GSPC, ^DJIA, ^IXIC, ^NDX, SPY, DIA, QQQ) remain mired in a bear market.

Having said this, is still too early to say that Operation Twist has failed. However, there is no gainsaying the fact that less than one month after the policy was announced, a key benchmark of failure has been registered -- long-term rates are higher than they were prior to Operation Twist.

The potential loss of credibility on the part of the Fed that could arise as a result of a failure of Operation Twist could have momentous consequences.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.