EDITOR NOTE: It’s been said, long before the current COVID-19 crisis, that “the Fed is out of bullets.” Well, now that the Fed had brought interest rates near zero, leaving little wiggle room above negative territory, it appears that the Fed found another set of bullets: bond yields. Monetary manipulation may “evolve” into bond yield manipulation. Like we said many times before, interventionists solve intervention-related problems with more intervention. Now we see it. Such a move is unprecedented, untested. What’s uncertain is the outcome. What’s certain is that central bank control and an artificial economy are becoming the norm--the destruction of “capitalism” to save companies and shareholders, which, as you can see, is just a bit ironic.
Get ready for the Federal Reserve to target bond yields as one of the many unprecedented measures the central bank has undertaken to support the economy.
The Fed may shift to a policy of buying bonds to cap yields for short-dated maturities at fixed levels, says Mark Cabana at BofA Global Research who argues the move is likely to take place in September as the Fed looks to mitigate the risk of deflation over the next few years.
The new policy may result from worries that the Fed currently lacks tools to support economic growth when policy interest rates are near zero anyway after the central bank moved aggressively to combat the recession resulting from the coronavirus pandemic.
In an interview with MarketWatch, the former New York Fed staffer, now at BofA, noted this so-called policy of yield-curve control hasn’t seen much use by other monetary policymakers. Only Australia and Japan have adopted the unconventional policy measure, so far.
Once viewed as an outlandish option only used by deflation-stricken Japan, yield-curve control has come up in recent discussions among senior Fed officials.
The minutes from the April meeting of the Federal Open Market Committee, the Fed’s interest-rate setting body, showed some central bank officials raised the possibility of its use. And New York Fed President John Williams and Fed Governor Lael Brainard have both come out in support of the policy.
Cabana says yield-curve control is likely to come in conjunction with forward guidance that interest rates will be kept low until certain inflation targets are hit to prevent investors from thinking that the Fed will tighten monetary policy at the first sign of price pressures resurfacing.
“From the Fed’s perspective, at least according to Brainard, we’re not only going to do forward guidance because we don’t believe we’re going to hit 2% PCE for a long time, but we even want to reinforce the fact that we will be quite accommodative after that. I think the market is under-appreciating this point,” he said, referring to the Fed’s use of personal consumption expenditures as its benchmark inflation measure.
One potential benefit could be that the Fed’s balance sheet may not grow as fast under yield-curve control versus a policy of pledging to buy a fixed sum of bonds every month. Once traders viewed the central bank’s promise to keep short-term yields as credible, they would stop betting on fluctuations in those maturities, curtailing the need for the central bank to keep buying bonds to anchor yields.
“They can have a smaller balance sheet than would otherwise be the case,” he said, pointing to how the Reserve Bank of Australia and the Bank of Japan had effectively eliminated volatility for the targeted maturities.
And investors may already be anticipating a policy change towards yield-curve control policies, too, with the spread between short-dated bonds and their long-dated counterparts widening out.
The yield spread between the 5-year note TMUBMUSD05Y, 0.463% and the 30-year bond TMUBMUSD30Y, 1.705% , a measure of the yield curve’s slope, has increased to 1.20 percentage points on Thursday, around its widest levels since 2017.
And the gap between the 2-year TMUBMUSD02Y, 0.228% and the 10-year note TMUBMUSD10Y, 0.907% hit 62 points, its widest since mid-March when forced selling in long-term government paper and illiquid bond markets sent the benchmark yield skyrocketing.
Cabana says an adoption of yield-curve control policy would not be without issues. Promising to keep the policy in place until inflation reached a certain level for a sustained period may mean the Fed will find it difficult to break away from yield-curve control, as the central bank has struggled to reach its 2% inflation target after 2008 even with the use of unconventional monetary policy tools.
Moreover, a promise to keep yields at certain rates could erode the separation of monetary and fiscal policy. A government that wants to ramp up spending may choose to borrow from shorter-dated maturities that are kept in check by the Fed.
“You could certainly have a future Treasury secretary that really tries to take advantage of that,” he said.
But that not might matter anyway given the Fed’s apparent willingness to buy all the bonds the Treasury Department is issuing to pay for the hit to the economy and the trillions of stimulus funds deployed so far.
“It is de facto monetization they are doing right now. The Treasury market functioning is under the auspices of private investors, but that’s going to move to the Fed,” said Cabana.
Originally posted on MarketWatch