In the past few days of financial turmoil, government bond yields in benchmark global markets have become dangerously volatile and dysfunctional.
Even in the US Treasury market, a flight to cash has caused longer-term bond yields to rise. This is directly contrary to the intentions of the Federal Reserve, which has explicitly stated that it is determined to ease monetary conditions and restore liquidity to financial transactions.
In seeking to reverse these developments, the Fed is probably considering introducing yield curve control, which would set explicit caps on government bond yields of several years duration. The US central bank has considered this strategy before and it is the path taken by the Bank of Japan in September 2016, and the Reserve Bank of Australia this month.
Why might this be necessary?
In the initial stages of the collapse in risk assets caused by the spread of the coronavirus, government bond yields behaved fairly normally, declining precipitously as the major central banks reduced policy interest rates and increased quantitative easing. This is what we would expect in a crisis, when the price of Treasuries — considered risk-free assets — goes up, pushing yields down.
By 9 March, US government yields appeared to be headed towards zero at the short-term and medium-dated parts of the curve, and even the 10-year yield dropped below 0.5 per cent. Since then, however, the market has misbehaved badly, briefly taking 10-year yields back above 1.2 per cent.
Real yields on 10-year inflation protected securities (Tips), a measure of the expected monetary stance, increased by 1.2 percentage points from their low point, suggesting that monetary conditions have tightened markedly.
So what has gone wrong?
There have been some technical reasons for rising yields, such as the unwinding of arbitrage trades in the bond market and a lack of liquidity among market makers. However, the main cause is almost certainly that institutions have been forced to raise cash to pay for client redemptions on their funds and to meet margin calls. US Treasuries are traditionally the most immediate source of liquidity in the financial system, and longer duration bonds have been heavily sold.
Normally, that would happen without a major rise in yields. But the current panic has been so sudden and dramatic that both nominal and real yields were greatly affected.
One explanation could be that the rise in yields reflected expectations of hugely rising budget deficits and higher inflation. That seems very doubtful, since the Fed is likely to finance most of the coming fiscal stimulus by increasing its balance sheet. In addition, 10-year break-even inflation expectations in the Tips market have remained extremely low, at 0.5 per cent. A more likely explanation is that the flight to cash is causing dislocations in the bond market itself.
The question now is how the Fed should fix this. So far, it has relied on extremely large injections of overnight liquidity, open-ended government bond purchases and facilities to cap the spreads in the commercial paper market and maintain the functioning of money market mutual funds. The introduction of yield curve control could, however, strongly reinforce the message that the Fed will not tolerate a dysfunctional Treasury market.
YCC involves a guarantee that the central bank will purchase any amount of bonds to cap yields at a chosen point on the curve. The Bank of Japan has fixed 10-year yields at around 0.0-0.1 per cent, while the Reserve Bank of Australia has less ambitiously capped the three-year yield at 0.25 per cent. The longer the duration chosen by the Fed, the more dramatic the effect would be on the bond market because yields on all debt of shorter duration are likely to be affected.
The Fed has seriously considered introducing YCC several times this century, including in a formal study in 2010. In a speech last month, Lael Brainard, a Fed governor, suggested that it could be used to reinforce forward guidance about monetary easing when policy interest rates next reached the zero lower bound, where they are today. If that is the main motive, the US might follow Australia’s central bank, fixing three-year yields close to zero. This would be the most likely choice in present circumstances.
If, however, the Fed wished to send a message that the entire bond market must rapidly return to normal at low yields, it could take the extreme step of fixing 10-year yields at, say, 1 per cent or less. Before 1951, the central bank succeeded for a decade in fixing 10-year yields at under 2.5 per cent, and this was not seriously challenged by the markets until inflation started to rise. So it could be done.
What are the chances that YCC will emerge at some point in the coming recession? Probably still less than 50 per cent, but certainly much greater than zero — and rising sharply.
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