To understand what is happening today, we have to go back to 1961. John F. Kennedy had just moved into the White House, and America was gripped by a dance craze called the Twist, made famous by Chubby Checker.
Kennedy faced a difficult dilemma. He needed to pull the US economy out of recession, which would have benefited from cheaper long-term borrowing. At the same time, short-term interest rates were higher in Europe, encouraging capital to flow out of the US.
Under the Bretton Woods system of fixed exchange rates, this also contributed to an outflow of gold. Foreign central banks accumulated dollars that had flowed out of the US and could exchange them for American gold at the official price of $35 an ounce. As pressure on the dollar mounted, fears grew that Washington might eventually devalue the currency, making gold more expensive in dollar terms – perhaps $40 an ounce rather than $35.
Washington therefore wanted two seemingly contradictory things: low long-term interest rates to support mortgages, investment and the wider economy, but relatively high short-term rates to discourage capital from leaving the country.
The Federal Reserve began buying longer-term Treasury securities and reducing its holdings of shorter-term ones, while the Treasury also adjusted its debt management to support the effort. The aim was to make the yield curve “twist”, with long-term yields moving down while short-term yields remained relatively high. The name Operation Twist was a contemporary reference to Checker’s hit.
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A New Twist
Sixty-five years later, a similar theme is returning. This time, however, the main player is not the Fed but the US Treasury.
Last week, the Treasury made a striking decision, departing from the plan it had announced only recently. It said it would at least double the maximum size of its buybacks of longer-term Treasury securities, while the government has also been relying more heavily on shorter-term debt to meet its financing needs.
The practical effect may once again resemble a twist. By buying back some longer-dated debt, the government reduces the amount of duration – and therefore interest-rate risk – that investors must absorb. To the extent that financing is shifted toward shorter maturities, that should, all else being equal, ease pressure on long-term yields.
This is not quantitative easing. Under quantitative easing, the Fed buys bonds using newly created bank reserves and expands its balance sheet. The Treasury, by contrast, cannot create bank reserves to finance its purchases. It must use existing cash or ultimately fund them through borrowing.
It therefore does not create new money in the way quantitative easing does. Instead, the buybacks remove longer-dated securities from the market. To the extent that the financing is shifted toward shorter maturities, the effect resembles Operation Twist, with less duration left for private investors to absorb. This time, however, the Treasury rather than the Fed is taking the lead.
Warsh Meets Political Reality
That makes Fed chairman Kevin Warsh’s position particularly important. He has argued that the Fed’s balance sheet should be “as small as practicable” and that interest rates, rather than permanent bond purchases, should remain the principal tool of monetary policy.
He has even described the Fed’s large balance sheet as something akin to fiscal policy in disguise. The suggestion that the Treasury is now stepping up its purchases of longer-term bonds precisely because Warsh opposes further expansion of the Fed balance sheet would, for now, be little more than speculation.
But if there is even a grain of truth to it, Warsh is already discovering, only months after taking office, how his bold ideas collide with political reality. The Fed chair favors a greater role for the market in determining long-term yields. The Treasury sees things rather differently. It now appears willing to exert greater influence over those yields in pursuit of its own objectives – and, ultimately, those of US President Donald Trump.
Trump, as is well known, wants lower interest rates. And someone appears to have pointed out to him that mortgage rates depend heavily on longer-term yields, which the Treasury can influence through its debt-management policy, not just on the short-term rates set by the Fed. The Fed, moreover, is plainly not going to bend to Trump’s wishes even under Warsh.
Trump is therefore killing two birds with one stone. He no longer has to wage war on the Fed, which would amount to admitting that he was wrong to nominate Warsh – just as, in his view, he was wrong to nominate Warsh’s predecessor, Jerome Powell. At the same time, the Treasury can help make mortgages cheaper for Americans, at least compared with where rates might otherwise have been.
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The Dollar as the Main Casualty
It is no secret that the United States is running large deficits and accumulating enormous debt. Under normal circumstances, investors would demand higher long-term yields to compensate for that fiscal risk. If Washington helps keep those yields lower through interventions including a modern version of Operation Twist, the underlying risk does not disappear.
Instead, some of it may show up in a weaker dollar. If long-term yields on dollar-denominated assets are pushed below the levels the market would otherwise demand, investors receive less compensation for the risks they are taking.
Fulfilling Trump’s wish for cheaper mortgages therefore comes at a cost. On this reading, the dollar becomes the main casualty of interventions resembling Operation Twist. Investors have even more reason to hedge against a weakening currency, adding momentum to what markets call the debasement trade.
The trade rests on the belief that traditional currencies will lose purchasing power over the long term because of high inflation, rising public debt, budget deficits or loose monetary policy.
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Bitcoin vs. Gold
Investors seeking such protection often turn to Bitcoin or gold. Neither pays interest and both are used as hedges against the erosion of conventional currencies. Yet in the current debasement trade, Bitcoin has been rising far more sharply than gold. Why?
First, its market is smaller. The same inflow of capital therefore has a much greater effect on Bitcoin’s price than on the far larger global gold market.
Second, Bitcoin is highly sensitive to global financial conditions. It is not only a form of digital gold but also a risk asset with a high monetary beta. In financial jargon, that means it tends to react disproportionately strongly to changes in the money supply and liquidity across the financial system. When markets begin to anticipate a weaker dollar, looser conditions and greater liquidity, Bitcoin often reacts much more strongly.
The third difference is the most fundamental: supply.
When the price of gold rises significantly, gold miners become more profitable. New mines are developed, existing ones are expanded, lower-grade ore becomes economical to extract and recycling increases. The recent rise in gold-mining stocks is a reminder of this relationship: higher gold prices create an economic incentive to produce more of it.
A new mine does not appear overnight, of course, and gold supply is highly inelastic in the short term. Over longer periods, however, it can respond to price.
Bitcoin is different. If its price rises from $80,000 to $160,000, miners can double the amount of computing power they deploy, but that will not create twice as much Bitcoin. Instead, competition increases and the mining difficulty adjusts. The long-term issuance schedule remains fixed by the protocol.
In short, gold’s supply can gradually respond to higher prices, while Bitcoin’s issuance does not respond to price at all. So when America twists, Bitcoin’s smaller market, greater sensitivity to liquidity and fixed issuance help explain why it can react much more strongly than gold.
Originally published on the author's personal website lukaskovanda.cz.
