It looks like QE3 will take the form of Operation Twist soon, a move designed to keep yields on long-term Treasuries - and alternative loan and securities rates -- down.
To achieve this, the Fed extends the duration of its portfolio without a corresponding increase in the size of its balance sheet. It will begin to purchase longer term Treasuries, with the capital flowing back to it from maturing securities they took on to their balance sheet as part of QE1.
The intended effect is to boost economic activity in two ways.
First, driving down Treasury yields nudges private capital increasingly into taking on risk in a search for income by buying corporate bonds.
Second, as most consumer loan rates are linked to longer-term Treasury securities the lowering of 5-10 year Treasury yields should drag down mortgage, auto and other consumer loan rates and increase consumption.
There are two basic ways the Fed can extend the duration of their portfolio, one direct and one indirect.
The Fed can steadily push out the duration of its portfolio by buying slightly-longer-term Treasuries, such as swapping 90-day maturing securities for 2-, 5-, 7-, and 10-year securities incrementally.
That would have a direct impact on the shoulder of the yield curve and cause consumer loan rates to decrease.
The indirect method is to take maturing short-term Treasuries, agencies, and MBSs and swap them for the 30-year bond.
The Fed would be bracketing its portfolio with very short-term Treasuries and very long-term Treasuries and this would corral private-sector capital into the shoulder of the yield curve.
The differences between these two methods would have a substantial impact on the composition of the private sector's bond market portfolio. And, of course, the two could be blended.
In the direct method the Fed is displacing private capital from the middle or shoulder of the yield curve and pushing it unilaterally further out on the curve in search of yield.
What's problematic is that the Fed becomes the primary driver of the value and yields on the most economically important Treasuries. It places the Fed in front of private capital. The Fed would be painting itself into a corner by decreasing the breadth of private capital in those securities and making it difficult to exit those positions in the future.
The Fed's goal should be to reduce investors' interest in both ends of the yield curve and encourage private capital into the middle of the curve to force yields down on the 2- to 10-year Treasuries.
Private capital would become increasingly concentrated into the middle of the curve and would be confident in doing so because it would not have to contend with the potential for the Fed to attempt to exit positions there in the future.
By implementing the indirect bracketing system, rather than just pushing duration out incrementally on the curve, the Fed will essentially be acknowledging that they will be operating with an expanded balance sheet for a very long time and will absorb the risks associated with inflation over time.
But the risks of pushing slowly out from short to long are greater than bracketing.
It is possible that the Fed will mix and/or alternate between these two approaches as their balance sheet composition changes and they can see the impact on the composition of private sector bond portfolios.
Right now, the markets are priced exclusively for the direct and steady pushing from short to long by the Fed with no consideration given to the potential for an indirect or bracketed approach.
As such, the 30-year bond represents the greatest immediate value on the Treasury yield curve. Right now it is yielding 3.34%. Whether the Fed opts for a direct or indirect approach to Operation Twist, that yield should fall to 3% and perhaps well into the 2s.