Macro Wrap-Up

No Country For Old Measures

Topics - Macroeconomics

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No Country For Old Measures

How do you face a problem you don’t understand? One way is to try every possible solution in the hope that one works. Some find this approach to be counterproductive and foolish. Someone who doesn’t believe in diversification might say, “you pick the one right tool.” 1 1 Close I’m not saying Yield Curve Control is a cattle prod.   The Fed has made its view clear. In response to the current crisis, Fed members have used almost every possible tool including rate cuts, lending facilities, swap lines, asset purchases and more asset purchases. So far, they seem to be achieving their goals. They have stabilized markets and kept bank lending flowing. But what if the economic recovery stalls? The Fed could add to the existing programs, in the hope that more volume would foster renewed growth. And if that doesn’t work, there is one additional tool.  

This tool is known as Yield Curve Control (YCC). Generally, central banks target short rates and leave the longer rates to chance. YCC is the practice of setting a second target for longer-term rates. The Fed used a version of YCC during and after World War II, then the Bank of Japan (BOJ) updated it and coined the name more than half a century later. 2 2 Close Federal Reserve Bank of New York: “Liberty Street Economics: How the Fed Managed the Treasury Yield Curve in the 1940s,” 4/6/2020.  In March, the Reserve Bank of Australia announced a target on 3-year government bonds. 3 3 Close The 3-year point is followed more closely than the 2-year in Australia.

In the WWII version, the Fed set a cap on the 10-year rate at 2.50%. 4 4 Close Meaning if the yield got above 2.5% they would buy bonds to bring it below that level.   This level was not chosen to serve a monetary policy purpose such as achieving full employment but was mandated by the government to lower the cost of debt incurred to finance the war effort. The yield cap helped the U.S. to reduce its deficit, but it created inflation. Many Fed members thought stoking inflation was bad policy and pushed for independence. This ultimately resulted in the 1951 accord with the Treasury allowing the Fed to set monetary policy and step back from the role of supporting the government bond market. 5 5 Close Of course, the executive branch exerted pressure on the Fed numerous times since 1951.   Whereas many citizens in the U.S. celebrated Independence Day last week with socially distanced BBQs, parades and illegal fireworks, Fed members enjoy a second day of festivities for their independence from the Treasury, which presumably they spend reading economic journals and drawing supply curves.  

The BOJ had a different motivation. BOJ Governor Kuroda had been struggling to get inflation up to target despite spearheading enormous QE programs. BOJ asset purchases had become so large that liquidity was drying up in the Japanese Government Bond market. 6 6 Close Reuters: “Helicopter money talk takes flight as Bank of Japan runs out of runway,” 7/30/2016.    It seemed like the BOJ might run out of bonds to buy. 7 7 Close In reality they weren’t running out. There were many more bonds for them to buy, but they were buying more than 100% of new issuance. Volumes in the JGB market were very low, and the BOJ had become the marginal buyer, so it made sense for them to set the price.   BOJ members wanted a way of increasing stimulus without having to add to the already swollen balance sheet. Ironically to achieve the goal of buying fewer bonds, they had to say that they were willing to buy an unlimited amount. They set the target for the 10-year yield to zero and later signaled an acceptable band of 10 bps on each side. If yields were to rise above 10 bps they would buy as many bonds as it would take to get the yield back down. 8 8 Close It’s not clear what they would do if yields got too low.   Few traders wanted to go up against an institution which has unlimited buying power, 9 9 Close Don’t tell that to the Swiss National Bank.   so the band has only occasionally been tested.

YCC helped the BOJ control the shape of the curve. A perceived risk of QE is that it can end up flattening the yield curve. Some economists believe that the flat yield curve in Japan had hurt bank lending. 10 10 Close The argument is that it makes it unprofitable to lend long, so banks don’t.   With YCC, a central bank can fix the longer-term yields at a higher level than short-term yields, thereby creating a positively sloping yield curve. 11 11 Close This was the best deal the BOJ could get. I won’t say the BOJ can create inflation, because they can’t.  

If the U.S. were to institute YCC today, it would look different from the BOJ’s version. The Fed would likely target the belly of the curve, most likely the 5-year point.  It would probably be a cap on rates, rather than the symmetrical target in Japan. The Fed doesn’t have the same concern about bond liquidity that the BOJ did, so YCC would be used as a supplementary form of communication to provide some extra stimulus. For the Fed, YCC is about commitment. It is a promise that it won’t remove any of the measures for a while. In the past the Fed has made commitments to keep rates low for a period of time or until the unemployment rate fell below a certain level. YCC would be taking that one step further. 

The problem with YCC is that it is difficult to unwind. 12 12 Close Anton: “You know how this is going to end, don’t you?” Llewellyn: “Nope.”   If one day a central bank announced an end to its YCC program, it could lead to a large jump in rates and some unwanted market volatility. The order of YCC would give way to the chaos of markets. But it would also be difficult to remove slowly. If a central bank raises the target rate a little, traders will know it is planning to remove YCC and act accordingly. This is the paradox of targeting a longer-term rate – it reflects expectations of the future path of rates. When a central bank controls it, a valuable piece of information is removed from markets. Rates may be better left to chance. 13 13 Close Carla: “The coin don’t have no say. It’s just you.”

Some Fed members have expressed skepticism. They question how effective the policy would be when rates are already so low. 14 14 Close “If the rule you followed brought you to this, what use was the rule?”   It does seem, however, that the Fed is seriously considering it, unlike negative rates which many members have said is not an appropriate tool for the U.S.  

If the Fed were to institute YCC, it probably would have a slightly positive effect on risk assets because of the signaling. Stocks seem to like Fed stimulus. After the RBA instituted a target on 3-year rates, the Australian yield curve steepened as 10-year yields fell by less than 3-year yields. The reason is that the policy gave investors confidence that the economy would recover, and inflation would rise, so 10-year bonds became less attractive relative to 3-year bonds. If the U.S. targeted the 5-year bonds, there is a good chance the yield curve would steepen as it did in Australia. But because of the Fed’s ambivalence, the probability of YCC in the U.S. in the near term is a coin toss. Still, bets on YCC may be worth a lucky quarter. 15 15 Close  

What We Are Watching

U.S. CPI (Tuesday) and Retail Sales (Thursday)
A slate of key U.S. data will be published next week, with inflation and retail sales likely the most important for market participants. Core CPI was lower than expected in May, showing a sequential decline in prices for a third consecutive month due to deflation in apparel, hotels, and airfares. The Covid pandemic has been a negative shock to demand for a number of industries, and has quickly translated into deflation in the most heavily impacted areas. Price trends in June may be less clear, as the month began with widespread reopenings and ended with rising coronavirus case counts and signs that the reopening process might be stalling in a number of states. U.S. retail sales are subject to similar uncertainty. Sales surprised significantly to the upside in May, but remained well below their pre-Covid levels. Next week’s data will be important to gauge the extent of the recovery in consumer demand, although even a strong result might reflect positive trends early in the month that may have diminished more recently. 

Chinese GDP, Industrial Production, Retail Sales (Thursday)
China implemented aggressive lockdowns early in the year, resulting in a severe -6.8% YoY decline in first quarter GDP. Since then, China has been relatively successful in containing domestic cases of Covid-19, which has allowed for the reopening of business activities ahead of most other countries. However, trends in Chinese growth data have been decidedly mixed as the reopening process has progressed. Manufacturing has rebounded more rapidly than expected, with industrial production returning to positive YoY growth in April. Consumer spending, on the other hand, has been slower to recover, with retail sales still showing meaningful YoY declines in May. This week, China’s National Bureau of Statistics will publish data on GDP growth in the second quarter as well as industrial production and retail sales growth in June. Signs of a broader or more forceful recovery in Chinese growth data might boost hopes that the rest of the global economy will follow a similar path later in the year. 


European Council Meeting (Friday, July 17th and Saturday, July 18th)
The European Council will meet in-person for the first time since the pandemic started to discuss the EU recovery plan proposed by the European Commission in May. The contentious part of the proposal is the provision of sizable grants to countries hit hard by the pandemic, to be funded with debt issued by the Commission. The proposal is supported by Germany and France but faces opposition from the so-called “Frugal Four” group of countries which appear wary of embarking towards a future of fiscal union or debt mutualization in the EU. Negotiations are expected to center around the size of the grants and the conditionality attached to them. If passage of the recovery plan appears to be in serious doubt, it could generate a negative reaction in European equity markets and could weigh on the euro. The discussions will take place one day after the ECB’s next policy meeting, where expectations for new stimulus appear to be low after the central bank expanded the size of its asset purchase program and extended its duration last month.

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