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Yield Curve Control and What It Could Mean for Clients

Yield curve control (YCC)—a strategy last used domestically 75 years ago—surfaced earlier this summer as yet another policy tool under consideration by the Federal Reserve (Fed). Using YCC, the Fed would create an interest rate cap (or caps) along the yield curve, and pledge to buy enough securities to keep rates from rising above that level.

The Fed on YCC

An excerpt of minutes from the July 28-29 Federal Open Market Committee meeting, released August 19

“A majority of participants commented on yield caps and targets—approaches that cap or target interest rates along the yield curve—as a monetary policy tool. Of those participants who discussed this option, most judged that yield caps and targets would likely provide only modest benefits in the current environment, as the Committee’s forward guidance regarding the path of the federal funds rate already appeared highly credible and longer-term interest rates were already low. Many of these participants also pointed to potential costs associated with yield caps and targets. Among these costs, participants noted the possibility of an excessively rapid expansion of the balance sheet and difficulties in the design and communication of the conditions under which such a policy would be terminated, especially in conjunction with forward guidance regarding the policy rate. In light of these concerns, many participants judged that yield caps and targets were not warranted in the current environment but should remain an option that the Committee could reassess in the future if circumstances changed markedly.”

Last week’s release of minutes from the July Fed meeting revealed a lack of enthusiasm for the move as a means of keeping borrowing costs low.

According to the minutes, “Of those participants who discussed this option, most judged that yield caps and targets would likely provide only modest benefits in the current environment,” leading the Fed to conclude that they “were not warranted.” While the statement tamped down earlier expectations that YCC could be announced as early as next month, it also made clear that YCC “should remain an option.”

The Fed’s ongoing consideration of YCC is relevant to investment professionals, says Christian Brobst, Calamos Vice President and Associate Portfolio Manager, for the two significant risks it could introduce: the potential for increased inflation and the need to unwind the policy at some point.

And, he adds, “Any time the Fed discusses implementing a policy that hasn’t been used in 75 years, it’s a good idea to know what might come of it.”

Below Brobst provides some added perspective.

20% Inflation Resulted from Earlier YCC Strategy

Inflation as high as 20% was the result of a nine-year yield curve control strategy implemented by the Fed starting in April 1942. The U.S. incurred massive debt in order to finance its mobilization for World War II, and capped short- and long-term interest rates to keep borrowing costs low and stable.

As the U.S. continued to incur debt, according to a recent blog post by the Federal Reserve Bank of St. Louis, the Fed was obligated to keep buying securities to maintain the targeted rates—forfeiting some control of its balance sheet and the money stock.

After the war ended, FOMC members grew more concerned with addressing the rapid inflation that materialized. However, the Truman administration continued to favor a policy that maintained YCC (which also protected the value of wartime bonds by implying a price floor). Ultimately, after the peg on longer-term rates contributed to faster money growth and increased inflationary pressures and with annualized inflation over 20%, monetary policymakers prevailed over the fiscal policymakers, and interest rate targeting was ended.

Q: What would the Fed seek to accomplish with YCC?

A: I view YCC as an extension of existing policy. We’ve seen it work for foreign central banks, as well as domestically in the past.

The intention would be to provide additional economic stimulus if their primary tool—control of overnight lending rates—became ineffective due to the depth of a recession or a depression. Ideally, interest rates savings would be passed through to borrowers, including households that may want to purchase durable goods.

The internal benefit to the Fed is that it may end up having to use less of its balance sheet to support YCC than it would to achieve the same result through quantitative easing (QE).

YCC would also potentially free up bank capital. Banks obviously benefit from a steep yield curve, so to the extent that the Fed took incremental steps to force the curve to be steeper at certain points, that may free up additional bank capital for lending into the public market.

Q: Would the Fed actually need to purchase securities in order to accomplish that objective? 

A: Not necessarily. Potentially, the most important aspect of a central bank is that the market believes the bank will live up to the expectations it sets through its statements. In terms of the federal funds rate, we commonly refer to that as forward guidance. So with YCC, the Fed’s intention would be to convince the market that a certain price—like the price of a two-year Treasury note, for example—is the appropriate clearing level. The market would then begin to trade that instrument at the YCC rate.

Of course, the backstop intervention would be for the Fed to purchase notes up to the price they’ve set as their YCC cap. But to be clear, the Fed would not intend to implement YCC exclusively through purchases.

Q: If the Fed were to step in, which part of the yield curve would they most likely target?

A: The common belief now is that if the Fed were to implement YCC, they would do it in stages, and probably step out about three months to one year. But in theory, we could see the Fed implement YCC at any point on the curve.

For example, Japan set a target on their 10-year government bonds that’s been in place for years. Academically, there are some studies that show that Japan has actually had to purchase less long-term bonds under YCC than they would have through pure quantitative easing in order to have the same impact.

Q: What is your read on the Fed’s current view of YCC?

“If 2% average inflation becomes one of the Fed’s goals, in my opinion YCC would become more likely, because if the Fed put additional stimulus tools in place, they would hold rates down artificially for a period of time. In that case, the likelihood that we would see higher inflation would become greater.”

A: I think they would prefer to stick with control of short-term rates and intervention in the repo markets to make sure that funding sources are working. Essentially, I think they’d like to continue with bond purchase programs by using their balance sheet. That would hopefully provide the necessary stimulus to achieve their dual policy goals: full employment and stable inflation around a 2% target.

Interestingly, it appears that the Fed is going to introduce the idea of a 2% average target in September, and ultimately, it looks like it’s going to introduce the concept of a 2% inflation rate over time. If it does that, we can infer that since 2012, when the 2% symmetrical target became actual policy, we’ve run well below that level on an average basis. So the inference is that the Fed would be willing to let inflation run higher for a period of time so that it can achieve its average target over the long term.

So even though YCC isn’t an active policy now, if 2% average inflation becomes one of the Fed’s goals, in my opinion YCC would become more likely, because if the Fed put additional stimulus tools in place, they would hold rates down artificially for a period of time. In that case, the likelihood that we would see higher inflation would become greater.

Q: Some market observers believe that while the Fed hasn’t explicitly implemented YCC, their actions amount to a de facto YCC policy. Do you agree? 

A: I disagree. A large part of YCC’s effectiveness would be based on messaging the program properly and getting the market to assign credibility to it. YCC and QE are not the same thing, and again, the Fed is not currently engaged in YCC. Of course, if the Fed decides it needs to implement YCC, it will. The July minutes confirmed this.

Q: Would you expand on some of the potential risks associated with YCC?

A: When an economy gets overstimulated, one of the primary risks to consider is the impact on inflation. When the U.S. entered World War II, the Fed held rates low for a period of five years. After that, potentially as a result of demographic changes, inflation ran at 15% to 20% for a number of years. The Department of the Treasury wanted to keep rates low because it had to finance government spending, but the Fed essentially argued that it couldn’t allow rampant inflation to keep running.  

The second potential risk of YCC is determining how to unwind it. For example, if the Fed implemented YCC at the one-year point on the curve, and if it were committed to maintaining that rate for one year, the market would behave accordingly. However, if the Fed implemented YCC on the 10-year note, and if the market didn’t believe that the Fed would stand in place for that full 10 years, the question would become what quantity of securities the Fed would have to purchase to support their cap. The number would increase drastically if the market didn’t have confidence in the Fed’s conviction and persistence.

Q: Have the Trump administration or the Democratic leadership gone on record about YCC?

A: I‘m not aware of any commentary on YCC from the Trump administration. The Democrats have made it clear that they would like to engage in modern monetary theory.

Q: It seems that YCC would have broad implications for multiple asset classes. How would you expect YCC to impact fixed income investors?

A: Fixed income investors would have to reassess their income needs, and determine whether short-duration portfolios would be capable of providing income benefits because the Fed would essentially be taking rates to zero further and further out on the curve. In a steep curve environment—which YCC would likely generate—there’s also a benefit from rolldown. In the interim, total return opportunities may become greater by extending duration than by staying in short- or intermediate-term strategies.

Q: And how would it impact the equity market?

A: Low interest rates are good for risk assets because the discount of cash flows at lower rates leads to academically higher valuations.

Investment professionals, for more information, contact your Calamos Investment Consultant at 888-571-2567 or caminfo@calamos.com.

Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. Opinions are subject to change due to changes in the market, economic conditions or changes in the legal and/or regulatory environment and may not necessarily come to pass. This information is provided for informational purposes only and should not be considered tax, legal, or investment advice. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations.

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