The world is setting its sights on what could be the next big thing - yield curve control. What it means is that using bond purchases to pin down yields on certain maturities to a specific target. It was used by Bank of Japan four years ago to fight deflationary spiral. This year, Reserve Bank of Australia adopted its own version and speculation is rife that Federal Reserve and Bank of England will follow later this year. As this new extreme and unusual game goes global, it changes markets’ perception over the role of buyers of last resort, risk appetite, market volatility and portfolio asset re-allocation as it will intensifying a broader hunt for yield.

In the first half of 1940s when Federal Reserve controlled the yield curve, firstly, it created deeply negative real interest rates. Secondly, the policy left long-term bonds with the risk characteristics of short-term debt but a yield more than 200 basis points higher. Thirdly, the Treasury forced to pursue a policy of issuing across the curve, from 13-week bills to 25-year bonds then. Faced with investor preferences for the higher yielding, but hardly riskier, bonds, the System Open Market Account had to absorb a substantial quantity of bills. Fourthly, large-scale open market operations were required in the course of re-fixing, from time to time, to support the shape of the yield curve. In response, investors began to move their portfolios into shorter-term bills. The result was a massive shift in the composition of the Open Market Account as the Account bought bonds and sold bills to accommodate the changing maturity preferences of private investors. In another word, Fed had to buy whatever private investors did not want to hold at the fixed rates. As a result, the size of the Account increased from US$2.25 billion at the end of 1941 to US$24.26 billion at the end of 1945.

If repeated today, it will distort market risk preference as investor will move out the curve to pick up coupon income without taking on more risk and then ride the position down the curve, adding to total return, assuming a positively sloped yield curve. The 1940s experience showed that in the face of steady selling, bond yields rose from 2.22% in June 1947 to 2.39% in December and then to 2.45% a month later while monetary base double from 1942 until 1945. The Fed sought to cushion the reversal by buying bonds and selling (or running off) bills.

Secondly, this would cause the gold price to rise as US federal deficit is reaching "unprecedented" levels. Preliminary data suggests the federal deficit will be US$4 trillion this year, which is more than 15% of GDP and public debt to GDP could exceed 130% - a case comparable to when the World War II broke out. Monetary base will grow to support fiscal activity, in return will translate into higher inflation and the value of the principal of bonds will decline significantly. In March 1947, with nominal interest rates held down, inflation peaked at 20%, which resulted real interest rates - calculated by subtracting inflation from nominal rates - dipped below -15%. Currently, real yield on 10-year US Treasury is -0.5%, and gold price is around $1,734.

To-date, Fed is already buying huge amounts of Treasuries and keeping rates down. We shall check on Fed’s next commitment to fix the yield curve for an extended period to lower debt burden, or alternatively next step will be debt relief.
 

Chee Seng, Wong
CIO, Athena Advisors
wong-chee-seng@outlook.com