What is an Operation Twist
Operation Twist is the name given to a Federal Reserve monetary policy operation that involves the purchase and sale of bonds. The operation describes a monetary process where the Fed buys and sells short-term and long-term bonds depending on their objective.
Operation Twist is a form of monetary easing, but unlike quantitative easing, it does not expand the Fed's balance sheet, making it a less aggressive form of easing.
BREAKING DOWN Operation Twist
The name "Operation Twist" was given by the mainstream media due to the visual effect that the monetary policy action was expected to have on the shape of the yield curve. If you visualize a linear upward sloping yield curve, this monetary action effectively "twists" the ends of the yield curve, hence, the name Operation Twist. To put another way, the yield curve twists when short-term yields go up and long-term interest rates drop at the same time.
Operation Twist first came about in 1961 when the Federal Open Market Committee (FOMC) sought to strengthen the US dollar and stimulate inflows of cash into the economy. At this time, the country was still recovering from a recession following the end of the Korean war. In order to promote spending in the economy, the yield curve was flattened by selling short-term debt in the markets and using the proceeds from the sale to purchase long-term government debt. Remember there is an inverse relationship between bond prices and yield – when prices go down in value, the yield increases, and vice versa. The Fed’s purchasing activity of long-term debt drives up the price of the securities and, in turn, decreases the yield. When long-term yields fall faster than short-term rates in the market, the yield curve flattens to reflect the smaller spread between the long-term and short-term rates.
Also note that selling short-term bonds would decrease the price and, hence, increase the rates. However, the short end of the yield curve based on short-term interest rates is determined by expectations of the Federal Reserve policy, rising when the Fed is expected to raise rates and falling when interest rates are expected to be cut. Since Operation Twist involves the Fed leaving short-term rates unchanged, only the long-term rates will be impacted by the buy and sell activity conducted in the markets. This would cause long-term yield to decrease at a higher rate than short-term yield.
In 2011, the Fed could not reduce short-term rates any further since the rates were already at zero. The alternative then was to lower long-term interest rates. To achieve this, the Fed sold short-term Treasury securities and bought long-term Treasuries, which pressured the long-term bond yields downward, thereby, boosting the economy. As short-term Treasury bills and notes matured, the Fed would use the proceeds to buy longer-term Treasury notes and bonds. The effect on short-term interest rates was minimal as the Fed had committed to keeping short-term interest rates near zero for the next couple of years. During this time, the yield on 2-year bonds was close to zero and the yield on 10-year Treasury bonds, the benchmark bond for interest rates on all fixed-rate loans, was only about 1.95%.
A fall in interest rates reduces the cost of borrowing for businesses and individuals. When these entities have access to loans at low interest rates, spending in the economy increases and unemployment falls as businesses can affordably secure capital to expand and finance their projects.