Yield curve control more likely than market thinks, analyst says
After the Federal Open Market Committee lowered the fed funds rate target to the zero lower bound, yield curve control re-entered the market's lexicon, with many pundits expecting a September rollout.
But, with parts of the yield curve currently inverted, "the chance of the Federal Reserve yield curve controls is probably much higher than the market currently anticipates," according to Chun Wang, a senior analyst at Leuthold Group.
“The Fed’s over-tightening in 2018 caused materially tighter financial conditions, which eventually inverted the yield curve and triggered the big sell-off in December 2018,” Wang said. “Over the last three months, however, real yields and the dollar have come down significantly, providing much needed loosening of financial conditions.”
Wang noted, while most parts of the curve have been steepening the last few months due to powerful policy action, the 6-month to 2-year “dipped back into negative territory last month” and “the 2-3 year section of the 1-month U.S.-OIS curve inverted at the same time,” suggesting inversion should be watched.
“It is significant because during the first and second inversions, the front-end led the conventional 10-2Y curve,” he said. “This is even more discomforting given the massive policy responses we have seen over the last few months," he said. "Historically, easy monetary policy has led to steeper yield curves and expansive fiscal policy (higher fiscal deficit) has the same effect. Now, we have both in record amounts. Wouldn’t the entire yield curve be positively sloped?”
Much has been said about YCC, "and the flat-lining price action of the 10- year yield certainly looks like YCC is already here," he added. And while the latest FOMC minutes indicate discussion of YCC is in the early stages, Wang believes the Fed will go ahead if the market prices it in.
“We believe the bar to implement YCC is quite low because: 1) the U.S. has done it before (during and after World War II), and other countries (Japan and Australia) have done it recently; 2) it’s far more palatable than negative rates; 3) it could potentially prevent another episode of an inverted yield curve,” he said.
But if the Fed implements yield curve control, it will be different than the World War II-era version, according to Shahid Ladha, head of strategy for G10 rates Americas for BNP Paribas and BNP interest rate strategists Timothy High and Tu Donnelly..
"YCC proved a successful tool for implementing MMT during WWII’s fiscal needs. Regaining control of monetary policy (and reducing Treasury reliance on Fed support) took a number of years for the Fed and came at the cost of high inflation," they said. "This time, Fed YCC is likely to be an extension of forward guidance and not [Modern Monetary Theory], limiting the maturity of rate caps."
If YCC is used as forward guidance, rates should be at or below the cap "until the implied anchor maturity as all the carry/roll in the curve is eliminated," they said. They suspect a policy anchor in the three- to five-year range.
“If the Fed institutes YCC, the curve shape is likely to be dictated by the maturity targeted and time period over which the cap remains,” they said. “In the medium term, we would expect rate volatility to fall further under a formalized commitment to cap short to medium-term maturity yields.”
And, they noted, other nations are using yield curve control. “We expect the Fed’s foray into YCC to resemble Australia’s experience more than Japan’s.”
The initial market reactions in those nations could be of value to the Fed.
“We set the initiation of Bank of Japan YCC to day zero and observe the behavior of the yield level and curve,” they said. “Empirically, the targeted yield quickly reaches its objective. Beyond the effective cap’s maturity, the curve is likely to steepen.”