When cracks emerged in the $18tn US government bond market this month, the Federal Reserve sprang into action to ensure volatile trading conditions did not destabilise the world’s largest and most liquid financial benchmark.
In addition to slashing US interest rates to zero, the Fed ramped up its interventions in short-term funding markets and announced it would buy at least $700bn in Treasuries and agency mortgage-backed securities. The US central bank went even further this week, awarding itself the power to buy an unlimited amount of government bonds.
These measures have helped to bring back a semblance of order to a market where it had become alarmingly difficult to get deals done. Volatility has abated, though it still hovers near levels seen during the global financial crisis, according to a Bank of America measure implied by options prices.
Now, fixed-income investors are encouraging the Fed to wade into even more unconventional waters, and consider a policy last used in the US during the second world war: yield curve control.
The policy, long employed by Japan’s central bank, and more recently adopted by Australia, calls for the Fed to set targets for bond yields. If they rise above those levels, the Fed then buys as many bonds as necessary to bring them back in line.
“[It] is the next logical major policy step . . . if the rates market misbehaves,” said James Sweeney, chief economist and chief investment officer for the Americas at Credit Suisse.
Mark Cabana, an interest rates strategist at Bank of America, sees it as an effective tool to fix the malfunctioning Treasury market.
“Yield curve control has always been an extreme policy, but it is quite appropriate in the current environment because it serves to kill volatility,” he said. By setting a yield level and committing to unlimited purchases to maintain it, the Fed “allows market participants to reduce their positions in a more aggressive way, and allows the market to resume normal functioning faster”.
The central bank is currently buying Treasuries at a pace of $75bn a day, which Mr Cabana says could mean another two weeks or so of erratic trading conditions before the situation stabilises. By scrapping specific quantities, the central bank could solve the issue “within three days”, he reckons.
The Fed has gone to great lengths to ease strains in other debt markets, including corporate bonds, municipal debt and commercial paper. Many of these markets remain under pressure despite the Fed’s interventions, however.
According to Bob Michele, chief investment officer at JPMorgan Asset Management, there is more urgency for yield curve control now that US legislators have agreed to a $2tn stimulus package.
Spending of this magnitude means a greater supply of government bonds. Mr Michele believes yield curve control could help the market to absorb the flood of new securities.
“It is not just about allowing the Fed to support the [Treasury] market: it is about creating a palatable level for federal, state and local governments to fund themselves in the post-crisis recovery and for corporate America to fund itself,” he said.
Tiffany Wilding, Pimco’s US economist, said yield curve control could be put to use by the central bank as a way to signal its commitment to keeping interest rates at or close to zero until growth picks up. She envisions the Fed targeting two-year yields as a way to reinforce its guidance to investors on what it plans to do, and when.
Lael Brainard, a Fed governor, has endorsed this kind of approach. Last year chairman Jay Powell and vice-chairman Richard Clarida said it was something the central bank would consider in an economic downturn.
The policy is not without its risks — especially if the Fed targets longer-term rates but is slow to adjust to changing economic conditions. “How do you get out of it without some disorderly unwind?” Ms Wilding said.
Markets, too, could struggle to adapt to the end of such a policy, sending yields soaring. Analysts also warn it may be difficult to rein in fiscal spending if policymakers are accustomed to the Fed hoovering up any extra Treasury supply.
Moreover, Japan’s experience with yield curve control does not inspire confidence, said Michael Darda, chief market strategist at MKM Partners. He notes that since the policy was established in 2016, the country has continued to struggle to liberate itself from decades of deflationary pressures and anaemic growth.
But these are risks the Fed may be willing to stomach. As Mr Cabana sees it: “Desperate times call for desperate measures.”
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