With business beginning to reopen and risk sentiment improving, the US is likely to return to a degree of normalcy in the coming months. But the impact of Covid-19 has the potential to inflict structural damage to the economy over the coming years without appropriate monetary stimulus. The actions of the Federal Reserve Board, described by its Chairman Jay Powell as “strongly committed” to helping the economy, has already included large scale corporate bond purchasing programs and additional lending facilities. But to ensure rates stay low enough for business recovery, a process called Yield Curve Control (YCC) may be necessary.
Yield Curve Control is similar to QE in the sense that it involves the purchase of US Treasuries to influence bond yields. However, the main divergence between the two is that under YCC, the Fed sets a target for Treasury yields and purchases as many bonds as required to maintain this target. If implemented, this could include caps on short-term Treasuries potentially up to the 3Y tenor, mainly due to the fact that the overnight borrowing rate is the primary monetary policy tool. The Fed is less likely to bother controlling Treasuries with maturities above 10 years in order to restrict its asset purchases and endorse a steepening yield curve. But the program may include Treasuries with tenors up to 5 years as an additional measure. Any form of economic recovery in the next few years will not be smooth, so YCC would provide further support with benchmark interest rates already at near zero.
It is likely that the Fed will see how the economy copes in the coming months before deciding whether to implement YCC. However, should the US economy encounter problems down the road, the benefits of the program are cogent. As mentioned previously, YCC would help control borrowing costs to help sustain economic growth in the medium term. Furthermore, YCC would reduce the possibility of rate hikes which some economists predict to come late next year. With 3 consecutive months of falling CPI, including a 0.4% decline in April, there is ample opportunity for the Fed to extend to extend YCC out to longer tenors, should macroeconomic conditions disappoint.
The potential for a reopening of the economy has certainly enticed yield-searching investors. Recent recoveries in risk sentiment has prompted a sell off in bonds on the long end, prompting a widening of the Treasury Yield spread to 0.65% (9 June). This has been accompanied by a fall in the MOVE index – which calculates implied volatility on fixed income options contracts and is a primary measure of bond market fear – to the 60 mark from its highs of >150 in early March. A value of less than 80 indicates low risk concern and demand for interest rate insurance via options. Meanwhile, US equity indices like the NASDAQ have surged past pre-crisis highs and the put-to-call ratio has neared record lows. All this points towards a level of frenzied speculation severely detached from the fundamental economic outlook. One of the Fed’s primary problems over the coming months will be to juggle the need for sustained low borrowing costs with the potential for financial stability concerns from continual asset price inflation.
Of course, the program would be intricately tied to the Fed’s Forward Guidance regarding growth and inflation. If the Fed can convince investors that it will be indefinitely committed to the program, yield curve control will be easier. This would prevent large further additions in debt security purchases to its already bloated balance sheet. However, if inflation and growth improve earlier than expected, short term US Treasuries yielding close to 0 may become unattractive to investors, resulting in a short-term yield spike which would not be well received by equity markets. This would likely require the Fed to foot the bill to normalise yields.
While some have praised the decisive actions of the Fed in the past few months, the path for the coming years has been set in motion. Large scale asset purchases has meant the Fed has essentially surrendered its balance sheet for the foreseeable future. Interest rates are unlikely to rise from around 0 until at least 2022, requiring additional monetary policy tools like YCC to help the recovery. The situation strikes resemblance to the explicit interest rate pegs following World War 2, which will likely be accompanied with muted inflation and growth for some time.
- Colby Smith, “US yield curve steepens as 30-year Treasury falls from favour”, Bloomberg, 3 June 2020, https://www.ft.com/content/7ad69c8a-dba4-4b83-a6ce-12e2c07593a3
- Sage Belz and David Wessel, “What is Yield Curve Control?”, Brookings, 5 June 2020, https://www.brookings.edu/blog/up-front/2020/06/05/what-is-yield-curve-control/
- James Knightley, “What to Expect From This Week’s Fed Meeting”, 8 June 2020, https://think.ing.com/articles/federal-reserve-meeting-what-to-expect/