Yield-Curve Control Is a Bond Trader’s Nightmare

(Bloomberg Opinion) -- “Brainard — wow.”

That was how Russ Certo, managing director of rates at Brean Capital, summarized remarks this week from Federal Reserve Governor Lael Brainard. Ian Lyngen at BMO Capital Markets called her comments “remarkable.” I had the same feeling.

Technically, Brainard’s speech on Tuesday in New York was titled “Federal Reserve Review of Monetary Policy Strategy, Tools, and Communications: Some Preliminary Views.” But listening to her describe what were supposedly her personal views on how to best conduct monetary policy at the effective lower bound of interest rates, it certainly didn’t sound preliminary, even if she emphasized no conclusions have been reached just yet.

The upshot is this: If the U.S. enters a deep enough economic downturn to merit cutting interest rates to zero, and the Fed determines even more easing is needed, expect the central bank to start capping yields on short-to-intermediate Treasury securities by intervening with asset purchases to set rate levels it deems appropriate. In other words, yield-curve control.

Those three words should send a shiver up bond traders’ spines, given what a similar policy has done to the market for Japanese government debt. Every once in a while, there will be a story about bonds in the third-largest economy not trading for minutes, hours, or even more than a day because of the Bank of Japan’s curve-control policy. Like this. Or this. Or this.

Here’s one of the most relevant portions of Brainard’s remarks:

“I have been interested in exploring approaches that expand the space for targeting interest rates in a more continuous fashion as an extension of our conventional policy space and in a way that reinforces forward guidance on the policy rate. In particular, there may be advantages to an approach that caps interest rates on Treasury securities at the short-to-medium range of the maturity spectrum — yield curve caps — in tandem with forward guidance that conditions liftoff from the [effective lower bound] on employment and inflation outcomes.

To be specific, once the policy rate declines to the ELB, this approach would smoothly move to capping interest rates on the short-to-medium segment of the yield curve. The yield curve ceilings would transmit additional accommodation through the longer rates that are relevant for households and businesses in a manner that is more continuous than quantitative asset purchases.” 

It’s fairly straightforward logic. If Treasury yields reflect nothing more than expectations about the path of the short-term fed funds rate, and the Fed’s forward guidance signals it will keep its lending benchmark locked near zero for at least the next two or three years, then why shouldn’t yields on Treasuries with those maturities be capped at the same, near-zero rate? In 2011, for instance, two-year U.S. yields fell to as low as 0.143%, or roughly the midpoint of the fed funds range, and hovered around the upper bound of 0.25% for much of the next 18 months.

Of course, the difference is that back then, free markets dictated that yield level. By contrast, Brainard is envisioning the Fed strong-arming the $16.5 trillion U.S. Treasury market with whatever asset purchases are necessary to reach the desired outcome. Under her model, once the central bank meets its targets for inflation and employment, the caps would expire and those securities would roll off the balance sheet organically.

Brainard didn’t stop there, though. In a rare move for a Fed governor, she admitted that looking back, she and other central bankers were too hasty in raising interest rates:

“As we saw in the United States at the end of 2015 and again toward the second half of 2016, there tends to be strong pressure to `normalize’ or lift off from the ELB preemptively based on historical relationships between inflation and employment. A better alternative would have been to delay liftoff until we had achieved our targets. Indeed, recent research suggests that forward guidance that commits to delay the liftoff from the ELB until full employment and 2 percent inflation have been achieved on a sustained basis—say over the course of a year—could improve performance on our dual-mandate goals.”

Again, from a purely theoretical standpoint, you can see the logic. And it’s worthwhile to question whether something has changed in the historical — but not quite conclusive — relationship between the two pillars of the Fed’s dual mandate.

And yet, it’s hard to shake the feeling that all of this could just be central bankers getting too cute and bogged down in theory. After all, this talk of potential yield-curve control comes at a time when the Fed is having problems taming even very short-term interest-rate markets, which have been its primary domain for decades. As I wrote last week, it has basically thrown the kitchen sink at the repo market and it’s still not enough. In fact, just this week, it increased the size of its repurchase-agreement operation on Dec. 2, to $25 billion from $15 billion, in anticipation of year-end funding pressures. The Fed’s credibility has undoubtedly taken a hit in recent months. 

Obviously, the central bank could put its foot down to control longer-term rates — taken to the extreme, it could just buy an entire auction of two-year Treasuries at its desired yield level even if no other buyers wanted the debt at that price. But this would crush parts of the world’s biggest and most liquid bond market, and it’s unclear what the ripple effects of such a move would be.

Certainly there’d be less need for U.S. rates traders or strategists (imagine the research: yields will be little changed!). What would a period of strict yield-curve control mean for the bond markets when the Fed achieves its dual mandate? Would that create massive volatility in Treasuries and corporate debt when the caps are lifted? And what if inflation never reaches the central bank’s target? Are pension funds and other savers expected to survive near the effective lower bound indefinitely? Is the Fed fine with companies continuing to load up on cheap debt?

Again, none of this is official policy — yet. So far, it’s just Brainard daydreaming about what a new-and-improved policy would look like with interest rates up against zero. But make no mistake: This is a bond trader’s nightmare. 

To contact the editor responsible for this story: Beth Williams at bewilliams@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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