The Breakdown - Why Are Traditional Investors So Hungry for Yield Curve Control?

Episode Date: August 23, 2020

On today’s edition of The Breakdown’s Long Reads Sunday, our selections have to do with one of the hottest topics in central banking: yield curve control.  “What Is Yield Curve Control?” The first piece is from the St. Louis Federal Reserve and is a primer on YCC, including past U.S. implementations as well as versions from Japan and Australia.  “Market Jitters Show How Much Fed Medicine Matters” Our second piece is an op-ed about how dramatically markets reacted to this small detail from the Federal Open Market Committee minutes, and what it suggests for their desires involving YCC.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by crypto.com, BitStamp, and nexo.io, and produced and distributed by CoinDess. What's going on, guys? It is Sunday, August 23rd, and that means it is Long Reads Sunday. This is the episode each week where instead of doing my own analysis, we're featuring an interview, I read an article or two, as is the case this week, that teach about or inform on some important topic. This week, I'm doing a two-parter on yield curve control. It's a concept that was in the news in the context of the FOMC meeting from last month whose minutes were just

released this week. And it's a concept that I think you're going to be hearing a lot more about. So the two pieces I'm going to read today. The first is from the Federal Reserve Bank of St. Louis. It's called What Is Yield Curve Control? It was just written about a week ago. This is a primer. So if you've already familiarized yourself with this, if you have been thinking about and know about yield curve control, that's not the one for you. However, the second article is called Market Jitters Show How Much Fed Medicine Matters by John Authors from Bloomberg Opinion. That one is a little bit farther down. So skip ahead if you already know about Yield Curve Control, but want to hear that point of view. That said, let's do what is yield curve control from Tuesday, August 11, 2020 by Kevin L. Kleason, Research Officer and Business

Economist and Catherine Boken, Research Associate at the Federal Reserve Bank of St. Louis. Traditionally, the Federal Open Market Committee targets the federal funds rate as a primary tool to conduct monetary policy. The Fed funds rate is a rate with a very short maturity. Movements in the Fed Funds rate, which is an overnight interest rate, are thought to influence longer-term rates. Based on the most recent summary of economic projections, the FOMC expects to keep the Fed Funds rate at zero through 2022. This has led to discussion of additional tools to conduct monetary policy, with the federal funds rate effectively being at zero. One of these policies that has received some attention in the press, yield curve control. How does yield curve control work?

Similar to a policy rate, YCC aims to control interest rates along some portion of the yield curve. The yield curve is usually defined as the range of yields on treasury securities from three-month treasury bills to 30-year treasury bonds. However, YCC targets longer-term rates directly by imposing interest rate caps on particular maturities. Because bond prices and yields are inversely related, this also implies a price floor for targeted maturities. If bond prices of targeted maturities remain above the floor, the central bank does nothing.

However, if prices fall below the floor, the central bank buys targeted maturity bonds, the demand and thus the price of those bonds. The minutes of the FOMC meeting on June 9th to 10th noted that the staff highlighted three examples of YCC policies. Federal Reserve policy during and after World War II, the Bank of Japan's policy adopted in 2016, and the Reserve Bank of Australia's policy adopted in March 2020. YCC in the U.S. The U.S. incurred massive debt expenditures to finance World War II, and the Fed capped yield in order to keep borrowing costs low and stable. In April 1942, short and long-term, 25 years and longer, interest rates, were pegged at 3.8% and 2.5% respectively. These rate caps were largely arbitrary and were set at approximately pre-1942 levels.

As the U.S. continued to incur debt, the Fed was obligated to keep buying securities to maintain the targeted rates, forfeiting some control of its balance sheet and the money stock. The public generally preferred to hold higher-yielding longer-term bonds. Consequently, the Fed purchased a large amount of short-term bills, which also increased the money supply, to maintain the low interest rate peg. After the war ended, FOMC members grew more concerned with addressing the rapid inflation that materialized. However, President Harry S. Truman and his Treasury Secretary still favored a policy that maintained YCC, which also protected the value of wartime bonds by implying a price floor. By 1947, inflation was over 17%, as measured

by the year-over-year percentage change in the consumer price index. So the Fed ended the peg on short-term rates in an attempt to combat developing inflationary pressures. In combination with rising debt from the U.S. entering the Korean War in 1950, the peg on longer-term rates contributed to faster money growth and increased inflationary pressures. In 1951, annualized inflation was over 20%, and monetary policymakers insisted on combating inflation. Against the desires of fiscal policymakers, interest rate targeting was brought to an end by the Treasury Fed Accord in March 1951. YCC in Japan. The Bank of Japan implemented YCC in 2016 with the goal of exceeding its 2% inflation target. The short-term policy rate and 10-year rate on government bonds were set at negative

0.1% and 0% respectively. YCC complements Japan's quantitative and qualitative monetary easing and negative interest rate policies. QQE policy resulted in annual bond purchases of about 100 trillion yen until 2016, sharply increasing the size of the Bank of Japan's balance sheet. QQE with YCC lowered bond purchases to about 70 trillion yen in 2019. Additionally, the monthly inflation rate, as measured by the year-over-year percentage change in the CPI, has remained above zero since enacting YCC. YCC in Australia. More recently, the Reserve Bank of Australia implemented YCC.

Since its announcement on March 19, 2020, the RBA has purchased bonds worth $52 billion Australian dollars to maintain the 0.25% target on three-year bonds. The bulk of purchases occurred between March 19th and May 6th. Purchasing stopped until August 5th to 6th when the central bank purchased $1 billion Australian dollars, as a three-year yield was slightly above the target. Further purchases will continue if the yield deviates from the target rate. The yield generally stays within five basis points of the target. Costs and benefits. Current experiences in Japan and Australia, as well as the Fed's experience in the 1940s, suggests that YCC has been an effective tool at targeting interest rates along some portion of the yield curve.

As the minutes of the June FOMC meeting noted, the lessons from these three episodes suggest that a YCC policy can be implemented in such a way as to avoid a significant expansion in the central bank's balance sheet, assuming the absence of an explicit exit strategy designed to reduce the size of the balance sheet. However, those minutes also noted that many FOMC participants had remarked that it was not clear that there would be a need to adopt YCC as long as forward guidance remains credible on its own. However, it is important to acknowledge that every policy has drawbacks. For example, if the Fed were to adopt such a policy and if the public perceives that the Fed is

engaged in deficit financing, then it is possible that inflation expectations could rise, threatening the Fed's long-run goal of price stability. This happened in the U.S. in the 1940s and early 1950s and led to the Treasury Fed Accord in 51. Another worry is that YCC could distort market signals, thereby diminishing the value of information that monetary policymakers gleaned from the Treasury market. Finally, if the Fed were to adopt YCC, policymakers would have to grapple with the challenge of how to exit from policies designed to be temporary departures from normal. Thus, once the economy normalizes, it would be important to convey the YCC exit strategy to the

public in a clear manner to avoid potentially destabilizing outcomes. Complementing other policies. Overall, YCC can complement other policies, such as quantitative easing and forward guidance, especially when a central bank's nominal interest rate target is near zero. The policy can thus help align market expectations with the FOMC's expectations. Nevertheless, there are other risks associated with YCC, including potential threats to central bank independence and the requirement that the market believe that the central bank would keep interest rates on a path consistent with its target. Credibility is thus key to YCC, or any policy, for that matter. What's going on, guys? I'm excited to share that one of this month's breakdown sponsors is Crypto.com. Crypto.com offers one of the most cost-efficient

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What's more, interest is paid out daily, and you can add or withdraw funds at any time. Get started at nexo.io. That was set up in many ways for the second article which I want to read, which is by John Authors on Bloomberg Opinion and is called Market Jitters Show How Much Fed Medicine Matters. For investors, yield curve control is a big deal, so a hint that it isn't going to happen didn't go down well. Minutes to midnight. The world hasn't changed that much.

What the Federal Reserve says still matters a lot. For evidence, look at the market reaction on a quiet Wednesday in August when the minutes to the latest Federal Open Market Committee meeting were published. We had already heard the chairman's gloss on the discussion that the committee had, and there are ideal moments to unveil a new policy direction straight ahead. in next week's annual gathering of central bankers at Jackson Hall, Wyoming. But even so, there was one sentence in the minutes that turned the markets around. The words that mattered were, quote,

many participants judged that yield caps and targets were not warranted in the current environment but should remain an option. This commits the Fed to nothing at all. A year ago, it might indeed have been remarkable to hear that caps on bond yields, a very direct interference in the operation of the free markets, should, quote, remain an option. And the Fed is also leaving plenty of other radicals options open. Many participants also commented that, quote, it might become appropriate to frame

communications regarding the committee's ongoing asset purchases, more in terms of their role in fostering accommodative financial conditions and supporting economic recovery. That implies that the Fed is no longer thinking of its asset purchases as a rescue mission for an illiquid market, but as a weapon for stimulating the economy. And that in turn implies that big asset purchases will be with us for a long time. That kind of thing is generally good for asset prices. But what reverberated with the markets was the language about yield curve control. If many participants don't think it's needed, that is a strong hint that it isn't happening. And a separate sentence told us, of those participants who discussed this option, most judged that yield caps and targets would likely provide only

modest benefits in the current environment. Not only is yield curve control not warranted many of them think, but it wouldn't help much if it was attempted. The result was a sudden and sharp correction for 10-year real yields. Meanwhile, stocks gave up gains, setting a tone that continues in Asia at the time of writing, while gold also endured a sharp sell-off. The Fed might not think that YCC is a big deal, and think that there are better ideas for pumping up the markets in the economy, but the instinctive market reaction suggests that investors disagree. They think yield curve control is a big deal, and dislike the hint that it isn't going to happen in the U.S. that they feel this way tells us something about the market. As the following chart from Citigroup's global investment strategist

Rob Buckland shows, the latest dose of QE has been received differently from those that preceded it. The QE campaigns that followed the last financial crisis saw plenty of bond market volatility, and also saw yields rise as the asset purchases went on. This time around, the Fed hasn't so much calm the market as anesthetize it. As I've commented before, markets are behaving as though yield curve control is already in place. As a result, nominal yields have stayed put, while inflation break-evens have risen sharply. This is very unusual, and is redolent of the post-war policy now known as financial repression, when yields were deliberately capped to help the government pay off debts incurred to fight the war. Real yields, defined as the nominal yield minus current

inflation rather than predicted inflation, have just gone negative for the first time since the 1950s. If markets dislike those comments about yield curve control so much, it suggests that a lot of money is now resting on the Fed coming through with another dose of financial repression. and allowing inflation to rise. Here are some consequences. Real yields and banks. Nobody suffers from low real yields quite like banks. The relative performance of the largest U.S. banks has tanked this year, directly in line with the fall in real yields. Such low yields make it harder for banks to make a profit from lending. Over the last 10 years, bank stock's relative performance has tracked real yields almost perfectly. The one big exception came in 2012, when the Fed's promise of QE Infinity

brought real yields to a new low while bank stocks rallied. At that point, the correct belief was that QE wasn't in fact forever. This time, investors are behaving as though it is a permanent fact of life. This is rational enough if you believe the Fed is really going to opt for yield curve control. The Bank of Japan became the first major central bank to adopt explicit yield curve control targeting in early 2016. Japanese banks had been caught in the doldrums for a generation already at that point, but they have suffered fresh woes in the five years of YCC. Meanwhile, bank valuations have tumbled to levels barely higher than at the nadir of 2011 and 2012, when the banking industry had to deal with the debt-sealing imbroglio of the U.S. and the Eurozone

sovereign debt crisis. At present, U.S. banks trade for less than book value, while Eurozone banks trade for less than half their book value. That is mighty cheap. If they had been priced on the assumption of YCC for years into the future, maybe such cheapness is justified. If there is a way to craft a post-COVID recovery without such explicit interference in bond markets, banks might well be too cheap. International markets and inflation break-evens. Meanwhile, if the Fed is serious about letting inflation rise well above 2%, and the minutes have plenty of language that suggests that it is, that also has implications for international asset allocation. A few months ago, we went through possibly the greatest deflationary shock in history.

Inflation expectations have been steadily rising around the world since then. Rising inflation break-evens have correlated nicely with stock market performance, probably because any belief in increasing inflation tends to imply a belief that an economy has enough life to generate some demand. A world in which inflation is allowed to rise rapidly is a world in emerging markets can perform nicely, along with the U.S. It is not so great for Europe or Japan, which are much more deeply immersed in deflationary dynamics. So far, this reflects little more than a bounceback from a deflationary shock, but what if it continues? Real yields, sectors, and break-evens. Broadly, there are three possible paths. The first to assume that not

nominal yields stay pegged, and so either break-even's rise or real yields fall, or break-evens fall and real-yields rise. This would flow into some clear winners and losers. Falling real yields so far have been great for technology, the U.S., emerging markets, and cyclicals. They have been horrible for value, led by financials. If break-evens start to fail, that would be good news for defensive stocks, value in Europe. Meanwhile, Vincent Dillard, macro-stratist from Stone X Group, bangs the drum for Latin America as the ultimate inflation hedge. The region was hit. The region was hit. in the neck in the early weeks of the crisis. It has had disappointing economic data since then, and a number of South American countries have had particularly horrible COVID-19 outbreaks led by Brazil.

And yet, DeLard points out, it has actually outperformed the developed world over the last month, according to the MSCI indexes. If you want an inflation hedge, it may well be found in the unloved stock markets of Latin America. There is a final option that central banks don't lean on the bond markets and yields do rise as inflation expectations move higher. That seems unlikely in the near-term, but the extent of the market reaction to a couple of sentences in the Fed minutes suggest that it is being taken for granted that nothing like this will happen. In the longer term, if inflation really does return, abetted by the logjams and bottlenecks that must inevitably have been caused by the pandemic, then a return to rising nominal yields grows that much more plausible.

The market's response looks like an overreaction to me. The Fed seems very happy to move to a form of average inflation targeting, and to treat yet more huge asset purchases as a means to rebuild the economy. And that implies that we can safely assume a lot of easy money in the future, even if it comes in a technical form other than yield curve control. But if markets are that jumpy about this, it does imply that the risks of a genuine recovery, bringing with it an end to the financial accommodation, are being underestimated. If COVID-19 comes under control much quicker than expected, either through herd immunity or through a successful vaccine, the Fed could leave the field quickly and nominal yields could rise in a hurry. If you think this is going to happen,

maybe buy some banks.