Why is controlling the yield curve so important?
news-single-imgcaption” style=”width:240px;”>Daniel Kalt and James Mazeau
Ten years ago, during the financial crisis, central banks for the first time coordinated their action and set up large-scale bond buyback programs. They have thus ensured that, in the bond markets, the credit risk premiums of weak debtors do not increase further and that they do not reconstitute themselves any more.
In the summer of 2012, the European Central Bank (ECB) announced that it would do everything necessary to maintain the euro. In the process, it also launched its first bond buyback program. It has thus enabled financing conditions in the euro zone to remain at a low enough level so that debtors such as Italy, Spain and Greece can continue to face their abysmal debts.
The coronavirus crisis only further increases the debt of many countries, so that central banks are considering using even more powerful monetary policy instruments.
One of them is the concept of “rate curve control”. To explain this approach and how it differs from previous bond buyback programs, we must first go back to the fundamental mechanisms of the market. If it wants to exert influence on a given market or even control it completely, a central bank can do this in two ways.
Quantitative easing programs
It can intervene, for example, by buying or selling a certain quantity of securities in order to influence market prices. So far, that’s what the US Federal Reserve or the ECB has done with their quantitative easing programs.
In autumn 2014, in the midst of the euro crisis, the ECB thus announced that it would buy back 80 billion euros of European government bonds every month from January 2015. It determined the amount of bonds redeemed and influenced the trajectory of bond prices in order to achieve its objective of considerably lowering interest rates across the entire spectrum of maturities and for all public debtors.
In the case of controlling the yield curve, the central bank does the opposite. It already controls, at the short end of this curve, the market interest rates insofar as it fixes the key interest rate.
Except that the central bank now wants to block the level of the entire yield curve at a certain level, for example by setting a target value for the yield on a ten-year government bond. Once it sets the price, it must ensure that it is respected on the market. Thus, the quantity (of bonds, in this case) that the central bank must buy or sell becomes the “residual quantity” resulting from the interplay of supply and demand on the market.
A changing monetary paradigm
Today, this type of de facto government control over a bond market is already practiced by the Bank of Japan (BoJ). Other central banks may soon follow suit.
As a result of this change in the monetary paradigm, central banks should signal their propensity to buy the desired amounts of sovereign bonds and put them on their balance sheets in order to keep yields at a certain level within the target maturity range.
This practice is on the rise, so it is not surprising that some observers are already talking about a rampant nationalization of the public debt markets.
* Chief Swiss economist
** Economiste, Chief Investment Office
UBS Global Wealth Management