Yield Curve Control - Next Unprecedented FED step

Usually FED control the federal funds rates (Overnight Bank lending rate) and the longer/medium end (Like 5 - 30 years) are controlled by market - based on public confidence or worry,  health of economy, etc . But in Yield Curve Control (YCC) strategy, FED would bring down yields on certain bonds to a set target. The goal is to pin down rates on certain maturities using bond purchases. This is to stimulate the economy by providing low borrowing rates to business and individuals.

Bank of Japan (BOJ) adopted this in 2016 - to peg yields on 10-year Japanese Government Bonds around zero percent. Reserve Bank of Australia also deployed its own version this year - three-year government bonds remains near the targeted 0.25 per cent.

FED is one of the major catalyst in past bond & equities rallies and YCC can further boost bond, credit  & risky assets. There is lot of speculation that FED will deploy this by end of this year (although Powell played down the idea on June 10, said that the usefulness of this policy remains an open question)


What's Yield Curve?

It's a graphical representation between yields across different government bonds maturities. Ideally the short end of the yield curve gives less yield (lower risk because of the short duration left to maturity) vs the greater yield on 5 /10/ 30 year (Higher return because of the greater risk associated with longer maturity ). Yield curve can be a difference between 3 month/10 year , 2 year /10 year (Inverted curve widely used as one of the recession indicator ), etc   


 
 


Relation of Yield curve with economy 

For lending a loan , banks and private lenders will look government yield as a starting point and then scale up based on how risky the borrower is.  Usually banks borrow cheap short-term cash (based on the Fed-Funds rate ) and lend it out at a higher long term-rate. So  steeper yield curve ( lower short term and higher longer term) means higher profits for tem.  Business can borrow money at low-rates for share buyback, investment or dividends. Households can borrow money for low rate mortgage also. Depending on the risk/reward , investors can buy front end (shorter duration) or medium/longer end of the yield curve.


What FED might do ?


FED might peg shorter/medium-term bonds  to a certain target . Overnight  rates (Fed Funds rate) are already close to zero (till 2022 at least) and a target for short/medium term, will ensure a strong recovery.  


Effect on Bonds & Equities
 
Target term and set rate will ultimately determine the direction of these assets. If FED decides to go after 5-7 year treasuries, it will be positive for intermediate bonds. Current 10-year is 0.71 % , so if the target rate set on 10-year is 0.50 basis point ( 0.50%) , bonds will rally (price moves opposite to %). This will give a boast to equities because of TINA concept ( there is no alternative - Yield hungry investors will have to buy equities because there is very low yield on 10-year )  . Alternatively, a 100 basis point (1 %) target will result in the opposite.

  


Effect on Credit

Businesses with high debt load like air-lines / Automobile / Energy / REITS will get a boast with Interest rates Capping / cheap liquidity.    


Further readings/charts

- https://apps.newyorkfed.org/markets/autorates/fed%20funds
- https://fred.stlouisfed.org/series/T10Y2Y
- https://fred.stlouisfed.org/series/T10Y3M
- https://www.investopedia.com/terms/y/yieldcurve.asp
- https://www.boj.or.jp/en/announcements/release_2016/k160921a.pdf

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