Investors rethink yield curve control horizon as Fed raises doubts

July 2, 2020

NEW YORK (Reuters) – Investors are dialing back expectations that the U.S. Federal Reserve may soon move to implement yield curve control, with some of them welcoming skepticism from the central bank in considering such a move.

Federal Reserve minutes released on Wednesday showed serious questions were raised about the strategy. Some bond market players had become increasingly convinced that one of the Fed’s next moves would be to cap yields at a specific point on the curve, by buying 2- or 3-year maturities for example.

“The simple reason the Fed will be skeptical is that you are asking a central bank to embark on a very risky change in policy, and it’s not clear that where it has been attempted, it actually works,” said Andrew Sheets, chief cross-asset strategist at Morgan Stanley.

The Fed’s discussion has centered on whether to import the sort of long-term interest rate targeting currently used by the Bank of Japan (BOJ) and the Reserve Bank of Australia (RBA).

Various Fed members have talked about yield curve control the past couple of months. In May, Fed Vice Chair Richard Clarida and New York Federal Reserve Bank President John Williams said yield curve control could be a tool to complement forward guidance.

Yields on two-year, three-year, five-year and seven-year issues have fallen since the March stock market sell-off and since Fed officials started talking about yield curve control.

For a graphic on Yield control by stealth:

https://fingfx.thomsonreuters.com/gfx/mkt/jznpnzjaxpl/Pasted%20image%201593706556741.png

“I think there was a subset of market participants that saw (yield curve control) by September as a foregone conclusion,” said John Roberts at NatWest Markets, who added that the front-end of the U.S. Treasury curve “cheapened a bit following the release of the minutes, so it’s possible some were unwinding YCC trades”.

Analysts at Goldman Sachs said in a research note Wednesday that they no longer expect yield curve control to be introduced at the Fed’s September meeting, although they still expect the committee to recognize the policy as an option for the future in its framework review.

Fed officials did appear to favor crafting some promises about the future – in effect making a pledge not to raise rates until some goal is met.

“What they made very clear is (yield curve control) is not their first tool of choice, it is ahead of negative interest rates but behind explicit outcome-based forward guidance,” said Jason Ware, chief investment officer at Albion Financial Group.

Controlling bond yields by purchasing certain maturities of U.S. Treasuries would keep yields where the Fed desires and help keep credit and business lending rates low.

The expectation for yield curve control has come as the U.S. Treasury has greatly increased borrowing. It announced in May plans to borrow nearly $3 trillion in the second quarter, more than five times larger than the previous record, while the July-September quarter would see borrowing of $677 billion.

For a graphic on Monthly U.S. Treasury issuance by tenor:

https://fingfx.thomsonreuters.com/gfx/mkt/ygdvzwnlkpw/Pasted%20image%201593706697566.png

Marvin Loh, senior global macro strategist at State Street Global Markets in Boston, said he would take yield curve control “off my plate for 2020 unless we really see yields rise,” adding that if yields in the 3-7-year part of the curve were to get “out of control, particularly given how much issuance the U.S. Treasury has been doing, then the market would wind up more concerned.”

Still, the focus on yield curve control has “basically meant that the Fed has already accidentally implemented it,” said Jon Hill, U.S. rates strategist at BMO Capital Markets, citing five-years yields hitting all-time lows on Tuesday.

(Reporting by Saqib Ahmed, Kate Duguid, Herbert Lash, Sujata Rao-Coverley and Megan Davies; writing by Megan Davies; editing by Jonathan Oatis)