The Federal Reserve is once again in the spotlight as the June 2020 FOMC meeting gets underway today. Long gone are the simpler days of the Greenspan Briefcase Indicator. Today’s markets have wadded into unchartered waters with a global pandemic and a variety of geopolitical forces applying pressure. With current rates already cut to 0-25 basis points (bps), the discussion now turns to what other tools the Fed may use to keep the economy from falling into a deep recession. One of these tools is yield curve control (YCC).
What is Yield Curve Control?
Take a look at the current U.S. Treasury futures yield curve.
An upward sloping curve that gives higher yields to longer durations, which illustrates the risk of holding longer dated securities. With YCC, the Fed would look to place limits, or a target yield, for particular durations. For example, the Reserve Bank of Australia has recently set its 3-year bond target at 25 bps. The Bank of Japan has its 10-year yield capped at 0% (current overnight rate is negative).
Where does the Fed stand?
According to the minutes of the May FOMC meeting, the “Federal Reserve was committed to using its full range of tools to support the U.S. economy in this challenging time.” In addition, the minutes stated that some of the committee expressed support for the idea of Fed purchases of treasuries “on a scale necessary to keep Treasury yields at short to medium-term maturities capped at specified levels for a period of time.” This thinking would lend support to YCC.
What Effect Would YCC Have?
Depending on what the range of maturities targeted, the most obvious effect would be the expansion of yield curve spreads. The 2/10 spread would be the first spread to look at.
Source: St. Louis Fed
Of course, the unemployment numbers from last week steepened this spread. A nod to YCC or continued momentum of the “worst is over” narrative and more calls for a “V” shaped recovery would also help move this spread wider. The real shock would be YCC extending out to the 10-year maturity, collapsing this spread. But that would be a real stretch at this point.
Perhaps a more interesting spread would be the 5/30.
Source: St. Louis Fed
Much like the 10-year, the 30-year move reflects a bit of optimism after last week’s report. A YCC target in the 3 to 5-year maturities would help accelerate this spreads steepening.
No Foregone Conclusions to be Made
YCC is just one tool being discussed amongst market participants. Forward guidance is another weapon in the Fed’s arsenal. This type of tool could be pledging to keep rates low until a certain threshold was meet — such as a level of unemployment or inflation — or a future date, for example, keeping rates on hold until 2022.
Truth be told, neither is a baseline expectation for this week’s meeting. The expectation is that the Fed will let the markets work it out for a while, especially given the recent strength in the unemployment number. Often times the Fed can have the desired effect by just mentioning support, letting the market speculate and keeping their fiscal powder dry. That could very well be the Fed’s plan. Create some chatter, keep an eye on the rumored economic recovery, and stand ready to act. But it’s a good idea to understand YCC and what it could mean. After all, remember what Mike Tyson said: “Everyone has a plan until they get punched in the mouth.”