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Sunday, 25 September 2011

Implications of Operation Twist on Asset Allocation


While main stream media and popular press "bang on" about sovereign debt, economic slowdown and downgrades in unison head-scratching about mid-year market declines, the practical aspects of trading these volatilities in capital markets is the management expertise of leading investors.

Leading asset managers re inevitably embroiled with global policy makers to best ascertain future policy impetus and implications for asset allocation shifts. For every twist and turn of central bank and government policies market participants get their heads around it and react with asset allocation decisions. Such as the implications of August 2010 annual Jackson Hole speech by Federal Reserve head Ben Bernake, which paved the way for what became Quantitative Easing 2 (QE2).

Since the 2H 11 global economic headwinds reflect possibility of re-entry into recession if not a slowdown, Ben Bernake and company have this time introduced Operation Twist as the subtle tinkering tonic for the capital markets aiming to ultimately restore economic confidence. Operation Twist attempts to control long-term interest rates instead of the usual monetary tool to direct short-term interest rates.

FPM's read on the intended consequences of this policy impetus is that the debt maturities are being extended or cheap money is available with longer time to re-pay it. The policy implementation is via open market operations to sell short-dated treasuries and use the proceeds to issue long-term bonds. If this action were applied and compared to a corporate credit referenced by default swaps it would be deemed by the International Swaps and Derivatives Association, the trade body for the derivatives market ISDA as “credit restructuring event”. I am reminded of bond tender plans e.g.. by Anglo Irish Banks and ISDA's verdict.

FPM’s high conviction belief is that in the week beginning 19th September and especially since Wednesday 21st September’s FOMC statement at 2:30pm announcing Operation Twist, portfolio realignment is underway. A shift into accessing cheap long-dated credit is currently the modus operandi of select institutional investors. Equities, and even safe-haven gold and to some extent commodities have been sold off  in anticipation and reaction to the Fed’s “twist” on the policy of using its balance sheet to boost financial assets – QE3 became a no-go policy! FPM bases this market opinion on the liquidity cycle’s observation about the flow of money between asset classes.

Remember that QE2’s support for fundamental issues such as jobs growth and on wealth effects seem uncertain. The financial asset purchases created mini asset bubbles which peaked in late April for equities, as indicated by bellwether S&P 500 reaching 1363. Since July 22 the same benchmark has been down-trending.

Notwithstanding the distraction of the ongoing Greek tragedy, together with this week’s downgrading of Italy’s credit rating by S&P, and contemporaneous credit downgrades of bellwethers financial services Citigroup and Bank of America, a new uptrend in investment assets is in the offing, at least until there is a new twist from economy and markets.

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