Interest rates are rising, but the Federal Reserve could still intervene to soften the impact of higher rates using a program known as “Operation Twist.”
Nerves on Wall Street have frayed recently, as evidenced by last week’s spike in the CBOE Volatility Index (VIX), which broke above 30 on March 4.
Concerns appear to be linked to a rising interest rate environment, which has seen the 10-year U.S. Treasury yield jump above 1.50% for the first time since the onset of the pandemic.
As many will recall, the Federal Reserve cut interest rates to zero last year in response to the coronavirus contagion. Intervention by the Fed, alongside aggressive government stimulus efforts, catalyzed a massive rebound in the stock market—driving broad market indexes to record highs by the end of 2020.
At this time, it appears many market participants are reevaluating whether stock prices remain attractive amid a changing interest rate environment.
Rising rates don’t often receive a warm embrace from the stock market because they effectively drive up the cost of corporate debt and can therefore contribute to a decline in overall business profitability.
The recent bout of volatility suggests that investors and traders are currently debating how the rise in rates ultimately affects their prospects.
While there’s no telling where interest rates could go from here, it’s important to keep in mind that the Federal Reserve could also intervene once again to alleviate market-related anxiety.
On occasion, the Fed has responded to rising interest rate environments by deploying a bond program known as “Operation Twist.” The intent of this intervention is to stabilize the structure of interest rates across the time horizon (i.e. the yield curve).
In practical terms, the goal is to slow down the rate at which interest rates are rising so higher rates don’t threaten the vitality of a potential recovery. The Fed achieves this goal by purchasing longer-dated bonds (10-year and 30-year Treasuries) and selling shorter-dated bonds (2-year Treasuries).
Readers will recall that bond yields and bond prices are inversely correlated—meaning that when one goes up, the other goes down.
By purchasing longer-term Treasury bonds, the Fed can therefore force down associated yields—or at least slow down the rate at which they are rising. And by simultaneously selling shorter-term bonds (boosting short-term yields), the Fed can also help prevent dislocations in the yield curve.
The Fed has deployed Operation Twist several times in the past, most notably in 1961 and 2011, when economic conditions presented similar challenges.
It’s believed that such intervention can remove as much as 100 basis points (i.e. 1%) of pressure from Treasury yields, if not more. That means if the 10-year Treasury yield was expected to rise from 1.5% to 3.5%, Operation Twist could theoretically cap the ascent at 2.5%.
With Operation Twist in the Fed’s back pocket—and a fresh wave of congressionally approved stimulus money on the way—it’s a little more difficult to envision how higher rates could derail the “everything rally,” at least in the near term.
On the other hand, the markets have been anything but predictable over the past 12 months, so careful adherence to portfolio risk management in the coming months is essential.
Readers seeking to learn more about trading U.S. Treasury yields, like the 2-year and 10-year, may want to learn more about Small Exchange products such as the Small 10YR US Treasury Yield (S10Y). Additional information about trading yields and interest rates is also available via this link.
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Sage Anderson is a pseudonym. He’s an experienced trader of equity derivatives and has managed volatility-based portfolios as a former prop trading firm employee. He’s not an employee of Luckbox, tastytrade or any affiliated companies. Readers can direct questions about this blog or other trading-related subjects, to email@example.com.