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Wrapping your head around Operation Twist

"Operation Twist" sounds like a military campaign. Which is probably not far from the truth given the all-out war that seems to have been declared against the yield curve. Let's put it all into context.

The Yield Curve

The yield curve is simply looking at the yields offered at various maturities of debt instruments and plotting it on a chart. You can create yield curves for specific debt instruments such as federal government issued debt, corporate debt, debt of a certain credit rating, etc. The one that gets talked about most in the United States is the interest rates paid on U.S. Treasuries.

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Here is a sample yield curve:

Open Market Operations

When an interest rate decision is made by a central bank to raise or lower rates, that's referring to the overnight rate which is the rate at which banks lend to one another. There is actually no requirement for the banks to change the rate at which they lend to one another because the central bank says so, and when that happens the central bank can intervene through what is known as Open Market Operations. The central bank will buy or sell treasuries, or use federal reserves to borrow or lend, to change the supply and demand characteristics until the interest rate for lending between banks is the central bank's desired range. The overnight rate is indicated on the left most position of the sample yield curve graph above.

Normally, this is the only part of the yield curve that a central bank participates in. The overnight rate normally affects interest rates offered for savings account and loans or mortgages accordingly.

What Is Different Now

Lately, America's central bank, the U.S. Federal Reserve, has been doing more than just regular open market operations. The overnight rate is effectively 0 per cent as the Fed tries to stimulate the economy by trying to reduce the cost of borrowing for consumers. Unfortunately, you can't lower the overnight rate below 0 per cent and the central bank wants more stimulus.

Quantitative Easing

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Quantitative Easing is basically the same thing described above with open market operations except the Federal Reserve is buying treasuries further out on the yield curve (long-term rather than short-term securities) to decrease the interest rates along the entire curve. The central bank does this because it can't lower the overnight rate any more, and it wants more stimulus.

Credit Easing

Credit easing is very similar to quantitative easing. The mechanics are exactly the same: The Fed would print money to buy longer term debt instruments to reduce interest rates further along the curve. The only difference is that credit easing targets specific debt securities. For example, if the interest rate on five-year consumer loans for automobile purchases was still too high, the Fed could buy up auto loans to provide more liquidity in this area which would reduce interest rates for five-year auto loans.

Operation Twist

Operation Twist is different than quantitative or credit easing because instead of printing money to buy debt securities, the Fed would sell some of it's current inventory of short-term securities and use the cash raised here to buy longer term securities. This would increase shorter term rates and decrease longer term rates. Imaging placing your hand on the yield curve and twisting the curve around a point.

It's important to note that while the Fed initiated Operation Twist, the short-term rates didn't rise because of the tremendous amount of money being invested here. There is so much demand for short-term securities that there is no actual twist, just a decrease in longer term rates without the Fed having to print money (which is what happens with quantitative easing).

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Operation Torque

Operation Torque was speculated move similar to Operation Twist, except Torque would sell short-term securities to raise cash to buy very long-term securities (think 30-year bonds and longer).

Torque was not enacted, and probably won't be. But hey, you never know. Anything is possible in war.

Preet Banerjee, BSc, FMA, DMS, FCSI is a W Network Money Expert, and blogs at . You can also follow him on twitter at @PreetBanerjee

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About the Author
Personal Finance columnist

Preet Banerjee is a consultant to the financial services industry. You can follow him on twitter at  @PreetBanerjee. You can find his conflict of interest disclosure on his website. More

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