Market Jitters Show How Much Fed’s Yield Curve Control Matters

Just a little yield curve control to calm your nerves.

Photographer: Robert Cianflone/Getty Images

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Minutes to Midnight

The world hasn’t changed that much. What the Federal Reserve says still matters, a lot. For evidence, look at the market reaction on a quiet Wednesday in August when the minutes to the latest Federal Open Market Committee meeting were published. We had already heard the chairman’s gloss on the discussion that the committee had, and there are ideal moments to unveil a new policy direction straight ahead, in next week’s annual gathering of central bankers in Jackson Hole, Wyoming (which, unfortunately for the bankers, will be virtual this year, denying them the chance for some fresh air in the great outdoors), and in next month’s FOMC meeting. 

But even so, there was one sentence in the minutes that turned the markets around. The words that mattered were:“many participants judged that yield caps and targets were not warranted in the current environment but should remain an option.”

This commits the Fed to nothing at all. A year ago, it might indeed have been remarkable to hear that caps on bond yields, a very direct interference in the operation of the free markets, should “remain an option.” And the Fed is also leaving plenty of other radical options open: “many participants” also commented that “it might become appropriate to frame communications regarding the Committee’s ongoing asset purchases more in terms of their role in fostering accommodative financial conditions and supporting economic recovery.”  That implies that the Fed is no longer thinking of its asset purchases as a rescue mission for an illiquid market, but as a weapon for stimulating the economy — and that in turn implies that big asset purchases will be with us for a long time. That kind of thing is generally good for asset prices.

But what reverberated with the markets was the language about yield curve control. If “many” participants don’t think it’s needed, that is a strong hint that it isn’t happening. And a separate sentence told us: “Of those participants who discussed this option, most judged that yield caps and targets would likely provide only modest benefits in the current environment.”  Not only is yield curve control not warranted, many of them think, but it wouldn’t help much if it was attempted.

The result was a sudden and sharp correction for 10-year real yields:

10-year real yields jumped more than 5bps after the FOMC minutes

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Meanwhile stocks gave up gains, setting a tone that continues in Asia at the time of writing, while gold also endured a sharp sell-off. The Fed might not think that YCC is a big deal, and think there are better ideas for pumping up markets and the economy, but the instinctive market reaction suggests that investors disagree. They think yield curve control is a big deal, and dislike the hint that it isn’t going to happen in the U.S. 

That they feel this way tells us something about the market. As the following chart from Citigroup Inc.’s global investment strategist Rob Buckland  shows, the latest dose of QE has been received differently from those that preceded it. The QE campaigns that followed the last financial crisis saw plenty of bond market volatility, and also saw yields rise as the asset purchases went on. This time around, the Fed hasn’t so much calmed the market as anesthetized it:

relates to Market Jitters Show How Much Fed Medicine Matters

As I’ve commented before, markets are behaving as though yield curve control is already in place. As a result, nominal yields have stayed put while inflation breakevens have risen sharply. This is very unusual, and is redolent of the post-war policy now known as “financial repression” when yields were deliberately capped to help the government pay off debts incurred to fight the war. As this chart from Buckland shows, real yields (defined as the nominal yield minus current inflation rather than predicted inflation) have just gone negative for the first time since the 1950s:

relates to Market Jitters Show How Much Fed Medicine Matters

If markets disliked those comments about yield curve control so much, it suggests that a lot of money is now resting on the Fed coming through with another dose of financial repression, and allowing inflation to rise. Here are some consequences:

Real yields and banks

Nobody suffers from low real yields quite like banks. The relative performance of the the large U.S. banks has tanked this year, directly in line with the fall in real yields. Such low yields make it harder for banks to make a profit from lending. Over the last 10 years, as the chart shows, bank stocks’ relative performance has tracked real yields almost perfectly. The one big exception came in 2012 when the Fed’s promise of “QE Infinity” brought real yields to a new low, while bank stocks rallied. At that point, the (correct) belief was that QE wasn’t in fact forever. This time, investors are behaving as though it is a permanent fact of life:

Lower real yields mean low bank share prices

This is rational enough if you believe the Fed really is going to opt for yield curve control. The Bank of Japan became the first major central bank to adopt explicit yield curve targeting in early 2016. Japanese banks had been caught in the doldrums for a generation already at that point. But as the following chart shows, they have suffered fresh woes in the five years of YCC:

Yield curve control has led to persistent underperformance

Meanwhile bank valuations have tumbled to levels barely higher than at the nadir of 2011 and 2012, when the banking industry had to deal with the debt ceiling imbroglio in the U.S. and the euro zone’s sovereign debt crisis. At present, U.S. banks trade for less than book value, while euro-zone banks trade for less than half their book value:

Record low bond yields leave book multiples close to their crisis lows

That is mighty cheap. If they had been priced on the assumption of YCC for years into the future, maybe such cheapness is justified. If there is a way to craft a post-Covid recovery without such explicit interference in bond markets, banks might well be too cheap.  

 

International markets and inflation breakevens

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