I was reading the article Bernanke’s Twist Sharpens Year-End Anxiety Over Stimulus and In the article it says
The Fed on June 20 extended its Operation Twist program to swap $267 billion in short-term securities with longer-term debt through December.
What do they mean by swap short-term securities with longer-term debt?
What debt are they swapping and how?
What exactly is "Operation Twist"?
So "Operation Twist" is actually a pretty simple concept.
Here's the break down:
The Fed sells short-term treasury bonds that it already holds on its books. Short-term treasury bonds refer to - bonds that mature in less than three years.
Then:
Uses that money to buy long term treasury bonds. Long-term treasury bonds refer to - bonds that mature in six to 30 years
The reason:
The fed buys these longer-term treasuries to lower longer-term interest rates and encourage more borrowing and spending.
Diving deeper into how it works: So the Fed can easily determine short-term rates by using the Federal funds rate this rate has a direct effect on the following:
However this does not play a direct role in influencing the rate of long-term loans (what you might pay on a 30-year fixed mortgage). Instead, long-term rates are determined by investors who buy and sell bonds in the bond market, which changes daily. These bond yields fluctuate depending on the health of the economy and inflation. However, the Fed funds rate does play an indirect role in these rates.
So now that we know a little more about what effects what rate, why does lower long-term rates in treasuries influence my 30yr fixed mortgage?
Well when you are looking for a loan you are entering a market and competing against other people, by people I mean anyone looking for money (e.g: my grandmother, companies, or the US government). The bank that lends you money has to decide weather the deal you are offering them is better then another deal on the market. If the risk of lending to one person is the same as the risk of lending to another, the bank will make whichever loan yields the higher interest rate. The U.S. government is considered a very safe borrower, so much so that government bonds are considered almost “risk free”, but because of the lower risk the rate of return is lower. So now the bank has to factor in this risk and make its decision weather to lend you money, or the government.
So, if the government were to go to the market and buy its own long-term bonds it is adding demand in the market causing the price of the bond to rise in effect lowering the interest rate (when price goes up, yield goes down). So when you go back and ask for a loan it has to re-evaluate and decide "Is it worth giving this money to Joe McFreeBeer instead and collecting a higher yield?" (After all, Joe McFreeBeer is a nice guy).
Here's an example: Lets say the US has a rating of 10 out of 10 and its bonds pay a 2% yield. Now lets say for each lower mark in rating the bank will lend at a minimum of 1% higher and your rating is 8 of 10. So if you go to market, the lowest rate you can get will be 4%. Now lets say price rises on the US treasury and causes the rate to go down by 1%. In this scenario you will now be able to get a loan for 3% and someone with a rating of 7 of 10 would be able to get that 4% loan.
Here's some more info and explinations:
Why is the Government Buying Long-Term Bonds?
To understand the Twist, you need to understand what the Yield Curve is.
You must also understand that the price of debt is inverse to the interest rate. So when the price of bonds (or notes or bills) rises, that means the current price goes up, and the yield to maturity has gone down.
Currently (Early 2012) the short term rate is low, close to zero. The tools the fed uses, setting short term rates for one, is exhausted, as their current target is basically zero for this debt. But, my mortgage is based on 10yr rates, not 1 yr, or 30 day money. The next step in the fed's effort is to try to pull longer term rates down.
By buying back 10 year notes in this quantity, the fed impacts the yield at that point on the curve. Buying (remember supply/demand) pushes the price up, and for debt, a higher price equates to lower yield. To raise the money to do this, they will sell short term debt. These two transactions effectively try to "twist" the curve to pull long term rates lower and push the economy.
