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1.Wealth Management Research 8 September 2011Global risk watchAchim Peijan, strategist, UBS AGLets twist again?Dirk Effenberger, strategist, UBS AGThomas Flury, strategist, UBS AGLena 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 nextrescue?" 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. Global risk watchEconomic consequences of Operation TwistBox 1: What is Operation Twist?Economic data in the US have largely disappointed of late. This isOperation 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 conditionsterm 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 totor, 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 itis 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 mightFig. 1: US economic data and scenariosRisk case:not decline much from current depressed levels. As a consequence, Labor market indicators Base case: No QE3Need for QE3additional lending might be rather negligible. Effects on other asset Initial jobless claimsbelow 400,000 trend higherclasses and economic sentiment might be smaller than a compara- ISM manufacturingtrend sideways or higher trend lowerble increase in cash deposits, as in the case of QE.employment sub-indexISM non-manufacturingtrend sideways or higher trend loweremployment sub-indexNevertheless both measures tend to increase the pool of cash-like Nonfarm payrolls>150,000