Operation twist is a mechanism under which the Reserve Bank of India does simultaneous buying and selling of government securities (both short-term and long-term government securities) through open market operations (OMO). Operation twist is adopted by the Reserve Bank of India to revive the economic slowdown, bring down interest rates to boost investments.
Operation twist was first introduced in 1961 by the Federal Reserves in the US to stimulate the US economy. And the mechanism worked for the US to boost the economy by raising short-term rates. Though it was not that effective in lowering long-term rates, it was successful in lifting the US economy out of recession. The US Federal Reserve also carried out the ‘operation twist’ in 2011 to boost economic growth after the global financial crisis.
Price and yield have a negative correlation and hence move in opposite directions. When the Reserve Bank of India purchases long-term bonds, bond prices go up and the yields come down. Simultaneously, when the Reserve Bank of India sells short-term bonds, bond prices go down and yields go up.
As the Reserve Bank of India buys long-term government securities with the proceeds from selling short-term government, the demand for government securities goes up. Higher bond price offsets lower yield on long-term securities for investors.
This twist in the shape of the yield curve would make loans less expensive for the borrowers. Interest rates and bond prices also have an inverse relationship making loans cheaper if bond prices go up.
This would result in a lower interest rate on home loans, vehicle loans and other loans along with a reduced rate on bank deposits and other fixed-income bearing savings options.
In order to control the long-term yield, the first phase of ‘operation twist’ was carried out by the Reserve Bank of India on 23rd December 2019. RBI had sold Rs 6,825 crores worth one-year short-term bonds to buy 10-year long-term bonds worth Rs 10,000 crores that will mature in 2029. In the second phase of ‘operation twist’, the Reserve Bank of India sold Rs 8,501 crores worth one-year short-term bonds to buy 10-year long-term bonds worth Rs 10,000 crores. In the third round of operation twist, the Reserve Bank of India bought long-term government securities maturing in 2024 and 2026. Likewise, RBI has carried out operation twists in the last two years to revive the slowing economy.
Interest rates and bond prices have an inverse relationship. When interest rates go up, bond prices come down and when interest rates fall, bond prices go up. Bonds are nothing but loans to government agencies or to companies by the investor, for which the investor receives interest income at a fixed rate.
When the interest rates go up, newly issued bonds come with higher rates of interest providing higher income to the investor. This makes new bonds look more attractive than older bonds. So, the only way for older bonds to compete is by reducing bond prices. When the bond price reduces, the yield will increase. Similarly, when interest rates come down, bond prices will go up and the yield will come down.
Long-term bold yields matter to equity investors. While valuing stocks, investors compute the expected rate of return by adding an equity risk premium over a risk-free rate. Treasury bills and government securities are used to determine risk-free rates. That means the yield on long-term government bonds is usually used as the risk-free rate for computing the expected rate of return on equities.
Long-term bond yields reflect inflation and growth in the economy. When the economic growth is strong in terms of cash flows and when inflation is going high, bond yields also rise. In simple terms to explain, bonds compete with stocks in the financial market, as bonds are less risky investments.
Whenever long-term bond yields go up, the cost of investing in stocks also goes up making it look less attractive. Hence, a rise in long-term bond yields may pull investors away from the stock market. Similarly, lower long-term bond yields would boost long-term investors in equity.
The conventional method of RBI directly reducing the interest rate is not very effective as sometimes banks may not pass on the rate cuts. Hence, an operation twist is necessary to revive the economy. As the yield on long-term bonds comes down, the government can borrow money from the market at a cheaper rate. Similarly, it would also benefit the corporate sector to borrow at a cheaper rate from the market.
What is the impact of the Reserve Bank of India’s ‘operation twist’ on investors?
Investors who have invested in fixed income securities having exposure to long-term bonds will benefit from easing the yield of long-term bonds. As the loans get cheaper, borrowers or consumers will benefit from low-interest rates on retail loans. This will boost spending and consumption in the economy. As spending is one of the largest components of GDP, this will help in revival and the economy to grow.
What is the yield of government securities?
The yield of government securities refers to the interest rate that the government pays to borrow for different tenure. For example, if government security worth Rs 100 provides an interest of Rs10 per year, then the yield of that government security is 10%.