Are We Headed For “Yield Curve Control”?
By now you’re probably thinking what is “yield-curve-control” and why should I care? Yield-curve-control is a term that is widely used among macro-economists and students of interest-rate policy but not among the rest of us. In this article, we’ll discuss what it is, why it may be deployed and how it may impact the investments in your portfolio.
So, first off, what is yield-curve-control? Yield-curve-control refers to a seldom-used strategy by central banks to control interest rates. More specifically, central banks will purchase an unlimited amount of government bonds to support prices. The goal is to create a price “floor” in the government bond market and, consequently, an interest rate “cap.” It is important to differentiate yield-curve-control from quantitative easing. With quantitative easing, the goal of bond purchasing is simply to increase liquidity in the marketplace whereas yield-curve-control has a specific interest-rate target in mind (e.g., a central bank may want to “peg” its 10-year bonds at a rate of 2%).
Now for the key question, why would a central bank want to peg interest rates? If you ask the U.S. Federal Reserve Bank, the answer is that yield-curve-control is simply another tool in the toolbox to achieve its “dual mandate” of (1) price stability and (2) full employment. Obviously, yield-curve-control is not helping price stability so it’s really the economic prosperity/full employment objective that they’re arguably targeting. In this sense, yield-curve-control enhances business activity because it makes capital cheaper than it otherwise wants to be. Corporations become more inclined to borrow, make investments and hire employees while consumers become more capable of making large purchases on credit (e.g., homes). If you artificially lower rates, you’re providing a tailwind to the economy.
For the more skeptical economists, yield-curve-control is deployed primarily as a tactic to control borrowing costs for governments during periods of substantial borrowing by them. In other words, nations can borrow more when interest rates are lower because borrowing costs are not consuming a substantial portion of their annual budgets. So, critics contend that governments are manipulating the bond market simply to keep their costs under control during periods of excessive borrowing. If ever there was a need for the U.S. government to deploy yield-curve-control it is now. The Great Recession and now COVID have resulted in substantial government debt. As shown in the chart below, U.S. debt has climbed to over 100% of U.S. Gross Domestic Product (“GDP”) – a level not seen since World War II.
Source: Federal Reserve Economic Data
So, would central banks really manipulate the bond market in this way? Many would be surprised to learn that several countries, including Australia and Japan, have been actively deploying yield-curve-control in recent years. For example, in 2016 Japan’s central bank made a commitment to target a near-zero interest rate on its 10-year government bonds. Notably, this program has been successful and other central banks are taking notice. For example, data from Japan suggests that the use of capital for yield-curve-control has proven to be more efficient than prior efforts of quantitative easing (i.e., it has a greater effect per dollar deployed).
Perhaps you would be even more surprised to learn that yield-curve-control was actively deployed in the United States from 1942-1951. This is a particularly scary comparison to today because it demonstrates that to reduce its debt a government has an alternative to paying it down – it can use inflation to shrink it. That’s right, from 1942-1951 the United States shrunk its debt as a percentage of GDP not by paying it down but by letting the rate of inflation run well above their interest rate costs. This situation left them with a much more manageable debt load as a percentage of GDP at the end of the period. This realization has led to the expression that “inflation is not a bug but a feature” of federal policy in times of great debt. In other words, governments aren’t necessarily trying to control inflation during times of excessive debt, rather, they’re using it to their advantage. The downside of this tactic is that inflation acts as a tax on consumers as it reduces purchasing power over time – a phenomenon that, unfortunately, is most detrimental to the lowest income earners and retirees living on a fixed income.
Whether it is achieved by yield-curve-control or market forces, our bet is that interest rates will remain relatively low for the foreseeable future. Even though the Federal Reserve Bank has telegraphed rising interest rates in 2022, it seems inconceivable that we’ll return to the rate environment of the early 2000s where a 5% yield on a bank certificate-of-deposit was commonplace. Neither the U.S. government nor U.S. corporations could likely afford to return to that type of rate environment anytime soon.
Given the likelihood of interest rates remaining at relatively low levels, investing becomes more challenging. Both government and corporate bonds may prove less beneficial in the coming years as yields struggle to keep up with inflation – thereby leading to negative “real” yields (i.e., yields net of inflation). Stock market impacts are more difficult to ascertain as artificially low yields are a tailwind to corporations, however, rising inflation generally leads to rising employment costs and shrinking margins. This type of environment tends to be beneficial for “real” assets. Investments such as real-estate, land, precious metals, collectibles and various commodities are often top performers in this environment as investors rush to hedge the effects of inflation and protect purchasing power. Unfortunately, a simple broad-based buy-and-hold stock/bond portfolio may be the worst possible strategy. In our opinion, it may prove most beneficial to deploy a tactical approach to stocks with targeted sector exposures, a dynamic approach to bonds where duration is adjusted throughout the period of rising rates and a healthy allocation to non-traditional pro-inflation assets. We recommend discussing your portfolio’s risk level and diversification with a trusted financial professional.