Fed Forges Ahead With Operation Twist

(November 3, 2011) — The Federal Reserve has left Operation Twist and interest rates unchanged. 

The Fed decided to forge ahead with its plan to purchase longer-term securities while holding interest rates low through 2013. This week, the Fed’s Open Market Committee confirmed it would keep the federal funds target rate between zero and 0.25%, noting that economic conditions “are likely to warrant exceptionally low” rates at least through mid-2013. The implications for corporate pensions may be dismal for plan sponsors that have not yet implemented a liability-driven investing strategy, since the move by the Fed will likely drive up bond prices. On the other hand, plans that already own bonds — already pursuing LDI — will reap the benefits of escalating bond princes.  

In a statement, the Fed said: 

“Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect a moderate pace of economic growth over coming quarters and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee’s dual mandate as the effects of past energy and other commodity price increases dissipate further. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.”

In an effort to support stronger economic recovery, the Committee revealed that it would maintain its existing policies of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. “The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate,” the Fed said in a statement. 

While the Fed’s objective may help the beleaguered housing market and encourage corporate investment to get the overall economy on a sounder footing, the buy-back program may soon make longer-dated bonds even more scarce, driving up bond prices and detracting from the appeal of liability-driven investing for those considering a transition to the more risk-averse strategy, investment consultants told aiCIO in September. 

According to Scott Whalen, senior consultant at Seattle-based Wurts & Associates, the Fed’s potential purchase of long-term Treasury bonds to lower rates may aid institutions that are already pursuing LDI, driving up the value of their fixed-income investments. For those on the sidelines, however, still contemplating the benefit of LDI to lower their portfolio volatility, the funding strategy will become less attractive as a result of being pricier to implement.

“Plan sponsors have been reluctant to go into LDI for years, yet there’s plenty of room for everyone in LDI strategies,” Whalen told aiCIO. “Very few investors expected interest rates to go this low, and fewer still expect them to go much lower from here,” he said, noting that corporate pension funds have historically decided to pursue LDI because it was more important for them to stabilize their plan’s funded status and its impact on financial statements and decrease the volatility of their portfolios than it was to increase the value of their assets. “People who went into LDI didn’t expect interest rates to drop, so they got the added bonus of assets increasing, unexpectedly.”