Wealth Management Research 8 September 2011

Global risk watchLet's twist again?

• In light of recent disappointing economic indicators we keepour risk assessment of an economic recession and a subsequentunconventional monetary policy measure in the US at the highestpossible level (30-40% probability).

• Currently, we think "operation twist" (OT) is the most likely nextmeasure and could be announced at the next Fed meeting on Sept20/21.

• 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 Fed's 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.

Achim Peijan, strategist, UBS AG

Dirk Effenberger, strategist, UBS AG

Thomas Flury, strategist, UBS AG

Lena Lee Andresen, strategist, UBS AG

Related reports:• Global Financial Markets: "Will Mad Men

take over the Fed?", 5 September 2011• Global risk watch, " The fed to the

rescue?" update, 24 August 2011.• Global risk watch, "The Fed to the rescue,

again?", 5 August 2011.

This report has been prepared by UBS AG. Please see important disclaimers and disclosures that begin on page 5.

Economic consequences of Operation TwistEconomic data in the US have largely disappointed of late. This isespecially true for key leading indicators such as ISM and non-farmpayroll numbers (Fig. 2). The hope with operation twist is that it pro-vides a stimulus to the economy comparable to quantitative easingwhich Federal Reserve Chairman Bernanke explained in a Washing-ton Post op-ed on 4 November 2010 “Easier financial conditionswill promote economic growth. For example, lower mortgage rateswill make housing more affordable and allow more homeowners torefinance. Lower corporate bond rates will encourage investment.And higher stock prices will boost consumer wealth and help in-crease confidence, which can also spur spending. Increased spend-ing will lead to higher incomes and profits that, in a virtuous circle,will further support economic expansion.”

In theory, operation twist should support growth (Box 1). However,we think there are currently several hurdles: Long term yields mightnot decline much from current depressed levels. As a consequence,additional lending might be rather negligible. Effects on other assetclasses and economic sentiment might be smaller than a compara-ble increase in cash deposits, as in the case of QE.

Nevertheless both measures tend to increase the pool of cash-likeassets in the private sector and as such have similar effects. There-fore, we would also expect inflation expectations to increase, ingeneral, if a significant operation twist was announced at the nextFed meeting. Getting a positive growth impact without the inflationeffect is not plausible, from our point of view. As a consequence,we expect operation twist to be of a comparably smaller magnitudethan QE2, to ensure inflation expectations remain range-bound.

Box 1: What is Operation Twist?Operation Twist refers to a central bank oper-ation, first implemented by the US Federal Re-serve in 1961, in which the central bank buyslong-term (e.g. 10-year and longer) govern-ment bonds funded by the disposal of short-term bonds. Since Fed purchases decrease theamount of securities available in the private sec-tor, the Fed aims at raising their equilibriumprice and lowering respective bond yields. Sincea 30-year bond has a higher duration risk thana 2-year treasury note, the Fed would raise theprice of a riskier asset at he expense of possiblyhigher short-term interest rates. In doing so itis supposed to induce risk-seeking behavior.

Fig. 1: US economic data and scenarios

Labor market indicators Base case: No QE3Risk case: Need for QE3

Initial jobless claims below 400,000 trend higher

ISM manufacturing

employment sub-indextrend sideways or higher trend lower

ISM non-manufacturing

employment sub-indextrend sideways or higher trend lower

Nonfarm payrolls >150,000 <0

Other growth indicatorsISM manufacturing PMI trend sideways or higher trend lower

ISM non-manufacturing

composite indextrend sideways or higher trend lower

Consumer sentiment* trend highertrend sideways

or lower

Auto sales trend highertrend sideways

or lower

Inflation indicatorsHeadline CPI year-over-year

inflationtrend sideways or lower trend lower

Core CPI year-over-year

inflationtrend sideways or higher trend lower

Medium-term inflation

expectations**trend sideways trend lower

*from the University of Michigan or the Conference Board survey

Recent trend in indicators

speak for

against QE3 or are neutral

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.

**from the University of Michigan survey

Source: UBS WMR

Box 2: Compare effects of OT with QETo assess the effects of operation twist wewould focus on the similarities with QE andcompare the two measures in terms of "dura-tion units" removed from the private sector".E.g. during QE2 the Fed bought USD 600 blnof government bonds with an average durationof roughly 4 years and replaced those by cashwith zero duration. Overall this removed 2400of interest exposure (=600*4). This would cor-respond largely to the purchase of USD 600 blnof bonds with duration of 6 years and replacingthose by USD 600 bln of bonds with durationof 2 years from the central bank's balance sheet(i.e. 600*6-600*2=2400 "duration units").

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Wealth Management Research 8 September 2011 2

Potential 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 insum are more negative than positive for the US dollar. We think themost important transmission channel works through the real yieldimpact on the long end of the curve. Operation twist is designed toeither lower current ten year rates or at least keep them constant.At the same time, the purpose is to reflate the US economy, increasecredit growth and eventually economic activity. Such a monetarystimulus normally hurts the currency, even in the case that econom-ic activity should rise. Also short term, there is some chance thatat least initially the new policy lifts equities and global risk taking,which would typically also be negative for the US dollar.

One aspect, we think, should be positive for the currency withinoperation twist, is that the government and real estate owners willbe 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.

Fig. 2: US equity market during 1961 twist

500

550

600

650

700

750

Jun.60 Sep.60 Dec.60 Mar.61 Jun.61 Sep.61 Dec.61 Mar.62 Jun.62 Sep.62

DOW JONES INDUSTRIALS - PRICE INDEX

Operation twist is announced

Last operation by the Fed

500

550

600

650

700

750

Jun.60 Sep.60 Dec.60 Mar.61 Jun.61 Sep.61 Dec.61 Mar.62 Jun.62 Sep.62

DOW JONES INDUSTRIALS - PRICE INDEX

Operation twist is announced

Last operation by the Fed

Source: UBS WMR, Reuters

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What comes next: Operation twist?Overall, we do see an increased probability of a recession in the USand additional unconventional policy measures by the Fed in thenext six months. We therefore keep our probability assessment forthis risk event at 30-40%. The potential impact on financial mar-kets should be rather muted, as recession fears are at least partiallypriced in. While initially we would expect a boost for risky assetsafter an operation twist or QE3 announcement, this effect will likelyturn out to be temporary.

For more analysis on the impact of additional quantitative easingon asset classes we refer to our risk watch reports published on 5and 26 August respectively.

Fig. 3: Risk metrics of additional QE in the USMedium probability, but international dimension

0

1

2

3

4Likelihood

Potential impact

International dimension

Time horizon

24. Aug 05. Aug 08 Sept*

Explanation: The likelihood dimension represents theprobability 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 bringthe events out of the risk scenario and into baseline ter-ritory. Potential impact refers to the degree of diverseimplications for financial markets. While a score of 1would be associated with a stock market correction inthe order of 10%, 4 would correspond to an extremebear market such as the 2008 meltdown. The inter-national dimension rates the degree of spillover acrossmajor world regions. Finally, the time horizon describeshow imminent the risk scenario is over the two-yearhorizon we have chosen for these analyses.*Low because recession fears have depressed marketsalready and the positive impulse from QE or OT shouldbe rather short-lived.

1 2 3 4

Likelihood <10%10 to 20%

20 to 30%

>30%

Potential impact

Low Medium HighCatastro-

phic

International dimension

Sub-regional

RegionalTrans-

regionalGlobal

Time horizon< 24

months<18

months< 12

months< 6

months

Risk Assessment Score

Source: UBS WMRSource: UBS WMR

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Appendix

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