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Good morning. It’s Jenn Hughes here, helping Ethan out while Rob is away. The Nasdaq Composite is on its longest winning streak in two years and hedge fund managers are being offered “silly” money according to Marshall Wace. Tell me what else is new:

One for the history books 

When investors are happily pricing in an interest-rate cut by June, it can feel churlish to offer gloomy alternatives. But quiet moments in terms of market action are good ones for thinking outside the everyday. So here’s something to chew over: what if adopting yield curve control becomes a live US debate next year?

Last month, Bank of America’s Michael Hartnett mentioned the possibility in passing at the annual gathering hosted by Grant’s Interest Rate Observer, home of the bow-tied bear himself, Jim Grant.

It wasn’t Hartnett’s first mention and it didn’t raise many eyebrows in the room. Still, it jarred, to me, with the idea of yield curve control as part of the economic jump-start toolkit as used by Japan and, even more recently, Australia. That’s also the context in which it popped up in US chatter in 2020-21 when the economy was reeling from pandemic lockdowns.

Dust off your textbooks though, because Hartnett is thinking of it in terms of capping government borrowing costs as it was used by the US during the second world war and its aftermath, when the Federal Reserve bought up bonds as needed to keep yields steady.

“The reason YCC can become part of the debate is that investors rather than voters are likely to force fiscal discipline on the US government,” he said late last week, even as bond yields fell and rate cuts were quickly priced in.

He’s not alone. Société Générale’s Albert Edwards, another with a bearish bent, has talked about it too:

“There’s no appetite to get budget deficits under control. If you’re trying to do QT [quantitative tightening] in times with extremely loose fiscal policy then yields will rise,” he said. “Bond vigilantes have recently woken from their slumber but they can be chloroformed back to sleep, if needed, with YCC.”

To get there, we’d need a bond market that worried persistently more about the fiscal over the macro outlook. That would be a big shift. Last month, worries about government finances helped push yields higher only for them to ease again with the first whiff of an economic slowdown and accompanying rate cut hopes.

“The greatest credit event of all would be a recession in which US yields went up, not down,” warns Hartnett.


So how might we get there?

The UK’s 2022 gilt market meltdown is one recent example of what can happen.

Even without the shock of an unfunded spending rise in a weakening economy, higher-for-longer rates could also grind away at the market mood. Bloomberg this week estimated that the US Treasury’s annualised interest bill has just passed $1tn.

Granted that’s only a big round number, but it is a very big one, even for the US and it has doubled since early 2022. Unless rates return to zero and spending is frozen, those added costs will not entirely subside as formerly cheap borrowing gets refinanced at higher rates, adding to the overall interest cost. Official projections from the Congressional Budget Office, which some argue are too optimistic, look worrying:

Line chart of Projected US yields and average debt costs  showing No going back

Back to Hartnett for how yield curve control might actually come about:

“You get to a point where the world just says, ‘sorry, we’re not doing this anymore’, and you lose the people that are financing the deficit. Then the Fed is going to be forced to come in and buy Treasuries. You could argue, well, they could stop QT first. They could cut rates or they could reintroduce QE. But in extremis, [you could] get a situation where you’ve got a disorderly rise in bond yields and a disorderly decline in the dollar because the creditworthiness and the credibility of the US government is called into question. Then they’ll do what the Japanese did, and institute yield curve control and that’s just basically saying, ‘we’re going to defend this level, we’re not going to let interest rates go above it’. And that would obviously be a very powerful thing.”

Controlling yields has taken different forms. In 1941, the US’s entry into the second world war required a huge increase in government spending. By March 1942 the Treasury and the Fed agreed on yield curve control, anchored at the short end with bills at three-eighths, or 0.375 per cent in modern parlance, and long bonds at 2.5 per cent.

Yields were set a fraction above the market level shortly before the December 7 1941 Pearl Harbor attack, as the helpful chart below of the resulting textbook curve from the Chicago Fed shows:

Fixing the entire curve gave investors an easy trade: buy long and ride the slope down with bond prices rising as their shortening maturities pushed yields down. The Fed, meanwhile, was left holding most of the bills the Treasury sold.

For its part, Japan instead committed to a target yield for its 10-year bond in 2016, and Australia for its three-year note in 2020.

In each case, central bank credibility helped yield curve control succeed initially. Even though the US war version was never fully announced to the market, investors soon picked up on the general lack of volatility.

But extrication isn’t simple, as Japan is experiencing now. Australia’s yield curve developed a kink as recovery expectations picked up in 2021, throwing other rates out of whack, while in the US, a crunch in mortgage finance followed as lenders held back and eyed the newly fluctuating rates.

Hopefully as Japan continues to emerge from yield curve control, the concept will be relegated to a dusty discussion among academics and not become a real possibility in the world’s largest market. It’s worth having a think about what it might mean, though. Just in case.

One good read

Wellness in the land of Guinness: Seaside saunas are “the new pub” in Ireland.

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