Should the Federal Reserve employ Yield Curve Control?

(Sonia Ruan Ye & Koushik Karthikeyan)

The novel coronavirus tragedy has created fear and has a growing impact on the global economy.  

There is less trust in large banks after the 2008 financial crisis than before. Therefore, when a similar event takes place people change their behaviour and they do so by taking less risks. For instance, businesses are less likely to invest money or hire more people. Additionally, a worker is less likely to open its own business since it would involve taking a loan. All these effects have negative impacts on the economy. One way to mitigate the impact is by spending more in the short-term which would improve the long-term effect on fear on the economy.  

The Federal Reserve’s response has already aroused concerns about long-term financial stability. Due to the economic fallout from the COVID-19 outbreak, the Federal Reserve is thinking of implementing the monetary policy known as the Yield Curve Control following the steps of the Bank of Japan (BOJ) and the Reserve Bank of Australia (RBA) although it has not been tested in the United States yet. However, the Fed’s current chairman, Jerome Powell, stated he is open to this policy option. This policy caps long-term government bonds and other securities to keep longer-term interest rates low. The Fed would set a specific long-term interest rate target and buy as many bonds as necessary to achieve it. The Yield Curve Control may be needed for economic stimulus as short-term rates near zero but no official decision has yet been made since the issue is still being studied. This kind of strategy could prevent a recession or lessen the impact of a downturn. The last time the Federal Reserve capped yields was during and after World War II but has not done so since 1951. Although it was aimed at minimizing costs of war finance, this time it would be used to advance the Fed’s macroeconomic objectives. As Michael Makenzie, the Financial Times’ senior investment commentator said, reviving such policy should not be undertaken lightly. 

By implementing this approach, many questions have arisen regarding the benefits and effects of it, given rates remain near historic lows. 

An obvious benefit is, the Fed would be able to keep financial conditions loose, even tighter monetary policy environment. Furthermore, officials are uneasy that bond investors could push yields higher, increasing borrowing costs and short-circuiting a recovery in the economy. 

A negative effect of capping yields is that it might not work. Although the primary benefit of low interest rates is their ability to stimulate economic activity, by lowering costs of borrowing and helping spur spending on business capital, investments and household expenditures, it might not work in stimulating inflation. An analysis by the Federal Reserve Bank of New York found a mixed outcome for the Bank of Japan. The paper concluded that the policy is found to be unsuccessful “on the inflation front, at least thus far”. If Japan’s outcome using the YCC has been said to be unsuccessful, why should the US follow them? Trying such a strategy in the US or even Europe might have different results. Also, does the YCC help a central bank achieve its policy goals? 

Nevertheless, the credibility of the Fed’s announcement is key. For instance, if investors do not trust the Fed, they could sell their securities or two years’ maturity or less to the Fed. If this happened, the Fed would own most of the eligible securities, with consequences for interest rates overall. However, if investors do believe Fed’s announcement, the securities’ prices might move to the targeted levels, achieving Fed’s objective.  

Not everyone is confident the Fed’s Yield Curve Control will work. An opinion piece in Bloomberg stated the YCC as a “bond trader’s nightmare.” Taking BOJ as an example, there’s some success in the short-term, but in the long-term, it can lead to adverse effects, such as a liquidity trap. Moreover, YCC could make companies increase their heavy debt loans even more, while punishing pension funds and other savers. 

Outlook 

For now the benchmark 10 year treasury bonds, along with other short-term bonds, have had their yields stay low as investors keep safer, lower maturity debt in their portfolio amid speculation of a major second wave of Covid-19 in America. However, when the US economy begins to open with less risk of a major outbreak, there is likely to be a US stock market rally, with investors moving slightly from all types of bonds to equities where they can make quicker, larger gains. Furthermore, the lows of the market in March invited many new, inexperienced investors into the equities market. With this inexperience comes an opportunity for arbitrage traders to take advantage of the volatility and naivety caused by these new investors, again causing a flock to stocks. Both of these movements are likely to cause an increase in yields of bonds, which the Fed will not want because it will cause a disparity between the low interest rates they have encouraged through monetary policy and the interest rate provided by banks and other institutions. With this being said, as the US economy opens the stock-to-bond ratio (S&P 500:TLT) is likely to increase, producing an inverted yield curve. A movement like this occurred after the S&P 500 bottomed on march 23rd, as optimism took over investors’ thoughts and stocks rallied. This would signal an incoming recession which may actually cause a retreat to short-term bonds, keeping short-term yields low.  

With both the S&P 500 and iShares 20+ Year Treasury Bond ETF, an indicator of long term treasury securities, being fairly stable and the potential for the S&P to be bullish as the risk of coronavirus fades away, the stock-to-bond ratio will go up in the near future meaning the Fed need not worry about yield curve control at the moment. This is due to long-term bonds not being at risk of large fluctuations in the market as of now.  

Despite this, they will have to monitor movements away from these securities with longer maturities as business grows back to pre-pandemic levels because this can cause interest rates to rise and move away from the levels which the Fed would consider as suitable for the economy to recover from the global pandemic.  

References 

The Financial Times (2020). Fed minutes reveal more debate on capping bond yields. Available at: https://www.ft.com/content/b3efe0b0-48fb-466b-8be2-a0a8879ecd63 (Accessed: 8 July 2020) 

The Financial Times (2020). The Fed is rightly wary of embarking on yield curve control. Available at: https://www.ft.com/content/1caef3c8-35c5-438c-8b3c-ef17b02e1bef (Accessed: 9 July 2020) 

Schneider, H. (2020). Fed mulls promises for the future, appears to discount yield curve control. Available at: https://www.reuters.com/article/us-usa-fed-yields/fed-mulls-promises-for-the-future-appears-to-discount-yield-curve-control-idUSKBN2427AG (Accessed: 7 July 2020) 

Higgins, M. Klitgaard, T. (2020). Japan’s Experience with the Yield Curve Control. Available at: https://libertystreeteconomics.newyorkfed.org/2020/06/japans-experience-with-yield-curve-control.html (Accessed: 9 July 2020) 

Chen, J., 2020. Investopedia. [Online]  

Available at: https://www.investopedia.com/terms/y/yieldcurve.asp 

[Accessed 8 July 2020]. 

Eikon, T. R., 2020. Thomson Reuters Eikon. [Online]  

Available at: https://emea1.apps.cp.thomsonreuters.com/web/Apps/FundDetails?s=TLT.O&st=RIC&navigate=overviewpage 

[Accessed July 9 2020]. 

Eikon, T. R., 2020. Thomson Reuters Eikon. [Online]  

Available at: https://emea1.apps.cp.thomsonreuters.com/web/Apps/Index?s=.SPX&st=RIC&app=true#/Overview 

[Accessed July 9 2020 2020]. 

Keller, D., 2020. StockCharts. [Online]  

Available at: https://stockcharts.com/articles/mindfulinvestor/2020/06/stocks-overbought-bonds-overso-47.html 

[Accessed 8 July 2020]. 


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