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.
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.
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.
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