Financial Pacific - Let's Twist Again (third party)


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Financial Pacific - Let's Twist Again (third party)

  1. 1. Wealth Management Research 8 September 2011Global risk watch Achim Peijan, strategist, UBS AGLets twist again? Dirk Effenberger, strategist, UBS AG Thomas Flury, strategist, UBS AG Lena Lee Andresen, strategist, UBS AG• In light of recent disappointing economic indicators we keepour risk assessment of an economic recession and a subsequent Related reports:unconventional monetary policy measure in the US at the highest • Global Financial Markets: "Will Mad Menpossible level (30-40% probability). take over the Fed?", 5 September 2011 • Global risk watch, " The fed to the• Currently, we think "operation twist" (OT) is the most likely next rescue?" update, 24 August 2011.measure and could be announced at the next Fed meeting on Sept20/21. • Global risk watch, "The Fed to the rescue, again?", 5 August 2011.• Overall we expect operation twist to have a rather muted impacton asset classes. We do not expect any risk-on trading behaviortriggered by the initial announcement to be long-lasting.The recent series of weak economic data has led the market tospeculate that the Fed may announce new unconventional measureat the next FOMC meeting on Sept 20/21.In particular, the latest labor market data was very disappointingand prompted markets to revise the growth forecast lower. At UBSWMR, we now expect US real GDP to grow by 1.6% in 2011and 2.2% in 2012. We also continue to see heightened risk of arenewed recession.As underscored by Ben Bernanke during his speech on the economicoutlook on Thursday, the FOMC will reconsider different policyoptions at its next meeting on 20/21 September. However, wedo not expect additional quantitative easing (QE3) at this point intime. This is mainly due to the Feds dual mandate to promoteboth full employment and price stability. Therefore, given relativelyhigh headline consumer price inflation (3.6% in July), the thresholdfor the Federal Reserve to implement QE3 is much higher than inprevious times.One way out of this dilemma is to utilize a balance sheet neutraloperation. The most often stated option by market participants isso called "operation twist". Now we will look at what operationtwist is and how it could affect major asset classes.This report has been prepared by UBS AG. Please see important disclaimers and disclosures that begin on page 5.
  2. 2. Global risk watchEconomic consequences of Operation Twist Box 1: What is Operation Twist?Economic data in the US have largely disappointed of late. This is Operation Twist refers to a central bank oper-especially true for key leading indicators such as ISM and non-farm ation, first implemented by the US Federal Re-payroll numbers (Fig. 2). The hope with operation twist is that it pro- serve in 1961, in which the central bank buysvides a stimulus to the economy comparable to quantitative easing long-term (e.g. 10-year and longer) govern-which Federal Reserve Chairman Bernanke explained in a Washing- ment bonds funded by the disposal of short-ton Post op-ed on 4 November 2010 “Easier financial conditions term bonds. Since Fed purchases decrease thewill promote economic growth. For example, lower mortgage rates amount of securities available in the private sec-will make housing more affordable and allow more homeowners to tor, the Fed aims at raising their equilibriumrefinance. Lower corporate bond rates will encourage investment. price and lowering respective bond yields. SinceAnd higher stock prices will boost consumer wealth and help in- a 30-year bond has a higher duration risk thancrease confidence, which can also spur spending. Increased spend- a 2-year treasury note, the Fed would raise theing will lead to higher incomes and profits that, in a virtuous circle, price of a riskier asset at he expense of possiblywill further support economic expansion.” higher short-term interest rates. In doing so it is supposed to induce risk-seeking behavior.In theory, operation twist should support growth (Box 1). However,we think there are currently several hurdles: Long term yields might Fig. 1: US economic data and scenarios Risk case:not decline much from current depressed levels. As a consequence, Labor market indicators Base case: No QE3 Need for QE3additional lending might be rather negligible. Effects on other asset Initial jobless claims below 400,000 trend higherclasses and economic sentiment might be smaller than a compara- ISM manufacturing trend sideways or higher trend lowerble increase in cash deposits, as in the case of QE. employment sub-index ISM non-manufacturing trend sideways or higher trend lower employment sub-indexNevertheless both measures tend to increase the pool of cash-like Nonfarm payrolls >150,000 <0assets in the private sector and as such have similar effects. There- Other growth indicatorsfore, we would also expect inflation expectations to increase, in ISM manufacturing PMI trend sideways or higher trend lowergeneral, if a significant operation twist was announced at the next ISM non-manufacturing trend sideways or higher trend lowerFed meeting. Getting a positive growth impact without the inflation composite index trend sidewayseffect is not plausible, from our point of view. As a consequence, Consumer sentiment* trend higher or lowerwe expect operation twist to be of a comparably smaller magnitude trend sideways Auto sales trend higherthan QE2, to ensure inflation expectations remain range-bound. or lower Inflation indicators Headline CPI year-over-year trend sideways or lower trend lower inflation Core CPI year-over-year trend sideways or higher trend lower inflation Medium-term inflation trend sideways trend lower expectations** *from the University of Michigan or the Conference Board survey **from the University of Michigan survey Note: In our view, deterioration in growth indicators has to be coupled with deterioration in inflation indicators to warrant QE3. Therefore, they have to be seen in conjunction and not separately when evaluing this table. Recent trend in indicators against QE3 or are neutral speak for Source: UBS WMR Box 2: Compare effects of OT with QE To assess the effects of operation twist we would focus on the similarities with QE and compare the two measures in terms of "dura- tion units" removed from the private sector". E.g. during QE2 the Fed bought USD 600 bln of government bonds with an average duration of roughly 4 years and replaced those by cash with zero duration. Overall this removed 2400 of interest exposure (=600*4). This would cor- respond largely to the purchase of USD 600 bln of bonds with duration of 6 years and replacing those by USD 600 bln of bonds with duration of 2 years from the central banks balance sheet (i.e. 600*6-600*2=2400 "duration units"). Wealth Management Research 8 September 2011 2
  3. 3. Global risk watchPotential market implicationsOverall we expect operation twist to have a rather muted impact onasset classes. We do not expect any risk-on market behavior trig-gered by the initial announcement to be long-lasting.Bonds yields: No significant drop in bond yieldsIn 1961, the initial response of bond markets to operation twist wasan approximately 10 basis points fall in Treasury yields with five ormore years to maturity and an increase of 6-12 month T-Bill yields ofaround the same size. This time we would expect any effects to befocused more at the long end of the yield curve since the short endis bound by the fed funds rate being close to zero for the time being.The effect at the long end should be muted, given that yield levelsare already very depressed with USD 10-year Government bondsyields at around 2%. If the measure leads to a general improvementin business sentiment, yields could increase somewhat over time,like they did during the implementation of QE1 and QE2 reflectingan improving economic outlook overall. Also, inflation expectationscould increase somewhat leading to a further drop in real yields. Wewould not expect short-term yields to increase more than a few ba-sis points. These rates are more likely to stay close to the zero-boundgiven the expectation that the Fed will keep fed funds rate at cur-rent levels close to zero for the next 2 years.Effect on FX: Operation twist likely to hurt USDFrom a currency perspective several aspects are important, which in Fig. 2: US equity market during 1961 twistsum are more negative than positive for the US dollar. We think the 750 Operation twistmost important transmission channel works through the real yield is announcedimpact on the long end of the curve. Operation twist is designed to 700either lower current ten year rates or at least keep them constant.At the same time, the purpose is to reflate the US economy, increase 650 Last operation by the Fedcredit growth and eventually economic activity. Such a monetarystimulus normally hurts the currency, even in the case that econom- 600ic activity should rise. Also short term, there is some chance thatat least initially the new policy lifts equities and global risk taking, 550which would typically also be negative for the US dollar. 500One aspect, we think, should be positive for the currency within Jun.60 Sep.60 Dec.60 Mar.61 Jun.61 Sep.61 Dec.61 DOW JONES INDUSTRIALS - PRICE INDEX Mar.62 Jun.62 Sep.62operation twist, is that the government and real estate owners will Source: UBS WMR, Reutersbe able to lengthen the duration of existing debt at almost no cost.This means, the redemption risk on existing debt falls and by thisthe whole economy gets more robust in relation to changes of in-flation expectations or other economic stress that could hurt creditcontracts in the future.Effect on Equities: Muted impactLooking at equity markets in 1961, the effect at that time was rathermuted (see fig. 2). The Dow Jones index continued its rise duringthe time of the operation, stabilized for some months thereafterand then fell strongly. Clearly, any measure by the Fed to stimulatethe economy would have some positive effect on sentiment, as theFed would signal its willingness to limit market downside. There-fore, US equity markets could gain or at least stabilize in the shortterm. However, as some market participants have started to antici-pate QE3, an announcement of operation twist instead could provedisappointing. Therefore, the upside in US equity markets is limited,and will be rather short-lived in our view. The overall impact on eq-uity markets on a global level would likely be muted. General eco-nomic growth concerns and the risks emanating from the Eurozonewill dominate markets soon again in our view. Wealth Management Research 8 September 2011 3
  4. 4. Global risk watchWhat comes next: Operation twist? Fig. 3: Risk metrics of additional QE in the USOverall, we do see an increased probability of a recession in the US Medium probability, but international dimensionand additional unconventional policy measures by the Fed in the Likelihoodnext six months. We therefore keep our probability assessment for 4this risk event at 30-40%. The potential impact on financial mar- 3kets should be rather muted, as recession fears are at least partiallypriced in. While initially we would expect a boost for risky assets 2after an operation twist or QE3 announcement, this effect will likely 1turn out to be temporary. Time horizon 0 Potential impactFor more analysis on the impact of additional quantitative easingon asset classes we refer to our risk watch reports published on 5and 26 August respectively. International dimension 24. Aug 05. Aug 08 Sept* Explanation: The likelihood dimension represents the probability of occurrence. For a scenario to be consid- ered, a minimum probability of 5% will typically be re- quired, while any probability above 40% would bring the events out of the risk scenario and into baseline ter- ritory. Potential impact refers to the degree of diverse implications for financial markets. While a score of 1 would be associated with a stock market correction in the order of 10%, 4 would correspond to an extreme bear market such as the 2008 meltdown. The inter- national dimension rates the degree of spillover across major world regions. Finally, the time horizon describes how imminent the risk scenario is over the two-year horizon we have chosen for these analyses. *Low because recession fears have depressed markets already and the positive impulse from QE or OT should be rather short-lived. Risk Assessment Score 1 2 3 4 10 to 20 to Likelihood <10% >30% 20% 30% Potential Catastro- Low Medium High impact phic International Sub- Trans- Regional Global dimension regional regional < 24 <18 < 12 <6 Time horizon months months months months Source: UBS WMRSource: UBS WMR Wealth Management Research 8 September 2011 4
  5. 5. Global risk watchAppendixGlobal DisclaimerWealth Management Research is published by Wealth Management & Swiss Bank and Wealth Management Americas, Business Divisionsof UBS AG (UBS) or an affiliate thereof. In certain countries UBS AG is referred to as UBS SA. This publication is for your information onlyand is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis containedherein is based on numerous assumptions. Different assumptions could result in materially different results. Certain services and productsare subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible for sale to all investors.All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but norepresentation or warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS and itsaffiliates). All information and opinions as well as any prices indicated are currently only as of the date of this report, and are subject tochange without notice. Opinions expressed herein may differ or be contrary to those expressed by other business areas or divisions ofUBS as a result of using different assumptions and/or criteria. At any time UBS AG and other companies in the UBS group (or employeesthereof) may have a long or short position, or deal as principal or agent, in relevant securities or provide advisory or other services to theissuer of relevant securities or to a company connected with an issuer. Some investments may not be readily realizable since the market inthe securities is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify.UBS relies on information barriers to control the flow of information contained in one or more areas within UBS, into other areas, units,divisions or affiliates of UBS. Futures and options trading is considered risky. Past performance of an investment is no guarantee for itsfuture performance. Some investments may be subject to sudden and large falls in value and on realization you may receive back lessthan you invested or may be required to pay more. Changes in FX rates may have an adverse effect on the price, value or income ofan investment. We are of necessity unable to take into account the particular investment objectives, financial situation and needs of ourindividual clients and we would recommend that you take financial and/or tax advice as to the implications (including tax) of investingin any of the products mentioned herein. This document may not be reproduced or copies circulated without prior authority of UBS or asubsidiary of UBS. UBS expressly prohibits the distribution and transfer of this document to third parties for any reason. UBS will not beliable for any claims or lawsuits from any third parties arising from the use or distribution of this document. This report is for distributiononly under such circumstances as may be permitted by applicable law.Distributed to US persons by UBS Financial Services Inc., a subsidiary of UBS AG. UBS Securities LLC is a subsidiary of UBS AG and anaffiliate of UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report prepared by a non-USaffiliate when it distributes reports to US persons. All transactions by a US person in the securities mentioned in this report should beeffected through a US-registered broker dealer affiliated with UBS, and not through a non-US affiliate. The contents of this report havenot been and will not be approved by any securities or investment authority in the United States or elsewhere.Version as per June 2011.© 2011. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved Wealth Management Research 8 September 2011 5