The Federal Reserve has publicly announced that it is considering doing so, and many commentators have analyzed the implications. Officially, the central bank is conducting a “deeper analysis” on the control of the yield curve (YCC). But the tendency of the 10-year Treasury yield to stagnate in recent months raises an obvious question: Has the YCC already started?
To the uninitiated, the YCC is a commitment by a central bank to purchase a sufficient amount of long-term bonds to prevent the rate from exceeding a specific target yield. The objective is to stimulate the economy by removing interest rates at levels below those favoured by the market.
As a policy tool, the YCC is an alternative to quantitative easing (QE), which has prevailed for most of the last decade. While QE (an unconventional type of monetary policy) uses newly printed money as a general strategy to buy government bonds and other assets, QE focuses on the explicit management of specific interest rates through the purchase and sale of assets.
Why move from EQ to YCC? One school of thought argues that with interest rates close to zero – again – YCC is a more effective tool for boosting the economy than QE.
Does it work? The YCC has been used by the Bank of Japan (BoJ) since 2016. Opinions are divided, although the effects are visible. As a recent research note from the New York Federal Reserve indicates, the effects of the policy shift to YCC have become evident in financial markets. The 10-year Japanese bond “settled close to target and remained remarkably stable over the next two years”. Yield volatility, which was already much lower than in the US or German markets, decreased further, with the standard deviation of monthly changes being about half of the EQT period”
Four years later, what’s the verdict? As regards the objective of fighting inflation (Japan has long suffered from persistent disinflation/deflation), there has not been much progress. Core inflation in Japan is higher unless it remains unchanged at around 0.5%, which is the rate at which the CCJ has been implemented. There is reason for optimism: without the CCJ, core inflation might have fallen further. Perhaps, but a counterfactual is hard to prove – especially in macroeconomics – and so the jury is still out on this front.
As for the real economy, it is also a grey area. Japan’s pre-pandemic output, through the one-year GDP trend, has seen a moderate recovery after the CJC was set up in 2016. However, the resumption of growth was consistent with pre-2016 accelerations, so it is not clear to what extent the CJC contributed to the change.
For the United States, the Federal Reserve, in its report of 9 and 10 June, noted that “all participants agreed that it would be useful for staff to conduct a more thorough analysis of the design and implementation of short-term interest rate policies and their likely economic and financial effects”
Officially, the Fed does not target yields, although the recent stagnation of 10-year yields suggests otherwise. With a few exceptions, the 10-year rate has been exceptionally stable since April, remaining in a narrow range of 0.6 to 0.7%, with the exception of a short-term peak at 0.91%.
Coincidence? Perhaps, although with the increasing attention being paid to the YCC in the US, it is reasonable to wonder whether the Fed is testing the policy without officially announcing it and whether the market is now pricing its own version of the YCC as a foregone conclusion.
In any case, the arguments in favour of YCC are strengthening, according to a number of analysts. For example, Tim Duy (an economist at the University of Oregon), a seasoned observer of the Fed, expects the Fed’s doubts about YCC to “eventually fade” Why? As he explains on the Fed Watch blog: “My position assumes continued economic weakness, consistently below-target inflation and possible Fed reluctance to continually increase the scale of asset purchases” via the EQ.
He adds that “With a new wave of Covid-19 cases sweeping across some states, particularly in the South and West, it is becoming increasingly clear that we will not see a V-shaped recovery”
Ed Al-Hussainy, senior interest rate and currency analyst at Columbia Threadneedle Investments, also sees a growing argument for capping returns. “I expect YCC to be an active participant in the Fed’s toolbox on two fronts,” he told The Bond Buyer last month. Firstly, “as a means of cementing future directions on the front end of the curve and encouraging the Treasury to focus on issuing short-term bills and notes to finance the deficits of 2020-21”, and secondly, “as an option to cap long-term yields in the event of disorderly steepening of the Treasury curve”
There are many skeptics of the YCC, including members of the Fed’s Monetary Policy Committee. And according to some, the need to cap yields in the US is unnecessary as long as rates remain low.
The question is, has the debate become irrelevant? Jon Hill, U.S. Rates Strategist at BMO Capital Markets, says that the increased focus on YCC in recent months has “essentially meant that the Fed has already accidentally implemented it”
Editor’s note: The summary bullets for this article were chosen by the editors of Seeking Alpha.