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The market for U.S. government debt is among the largest, most liquid markets in the world. When yields on U.S. Treasuries move, so does everyone else.
Because investors generally perceive U.S. Treasuries to be risk-free assets, their yields serve as proxies for interest rates. When the U.S. 10-year (^TNX) or 30-year bond yield (^TYX) rises, so do loans (business loans, mortgages) of comparable duration.
For a central bank, rising bond yields mean higher borrowing costs. The nation’s central bank, the Federal Reserve, has said that isn’t a problem in it of itself — unless rates rise too fast too quickly.
“I’d be concerned by disorderly conditions in markets, or by a persistent tightening of financial conditions,” Fed Chairman Jerome Powell said March 4. At the time of his speech, bond yields were rising as the vaccine rollout continued across the country.
Still, the Fed has a tool called “yield curve control” (YCC) that it can deploy if longer-term bond yields rise to uncomfortably high levels. But what would it take for the Fed to use such yield curve control?
What’s the yield curve again?
Remember that U.S. government debt comes in all sorts of duration — as short-term as 3 months to as long-term as 30 years.
Normally, bonds on the longer end compensate investors for taking on longer “duration risk” in the form of higher yields. In such a dynamic, a “yield curve” plot of yields on short-to-long U.S. Treasuries will show an upward slope.
Sometimes, dramatic shifts in investor sentiment can “invert” the yield curve.
What’s yield curve control?
Under a YCC policy, a central bank would target bonds of a specific duration and purchase as many bonds as it takes to depress the yield to a stated target.
The first major example of a modern central bank trying YCC comes from the Bank of Japan. In September 2016, the BOJ announced that it would be targeting 10-year Japanese Government Bond (JGB) yields at around 0%, an explicit intention to keep long-term interest rates low.
An example of a modified YCC policy comes from the Reserve Bank of Australia. In March 2020, the RBA said it would purchase as many 3-year Australian bonds as it would take to get to a target of around 0.25%. In November 2020, the RBA lowered that target to around 0.1%.
The 3-year is, by definition, not as long as the 10-year, but the idea is that by pinning down medium-term yields, investors may follow along and accordingly bring down longer-term yields. For the central bank, this would also mean avoiding a bond-buying commitment that would be locked in for 10 years.
Is this the same as 'Operation Twist?'
Sort of. In September 2011, the Fed modified its “quantitative easing” program, which involved snatching up billions in U.S. Treasury securities and agency mortgage-backed securities.
The program had a unique strategy: the Fed would skew its purchases toward longer-dated Treasuries instead of shorter ones. The idea: to more aggressively depress longer-term interest rates, thus “twisting the yield curve.”
The endgame of Operation Twist is the same as yield curve control's: to bring down borrowing costs. But the 2011 strategy involved pre-setting the size of its purchases ($400 billion, for example).
By comparison, yield curve control gives the central bank flexibility on the size of its Treasury purchases — as long as the yield target is achieved. The benefit would be guiding investors to do the work for the central bank, in which case fewer purchases would be required. The downside risk would be losing credibility among investors and having to buy an outsized share of the market for a bond of a given duration.
Will the Fed deploy yield curve control?
Prior to the pandemic, Fed officials like Lael Brainard and Richard Clarida had entertained the possibility of using a YCC policy targeting medium-dated bonds. But the Fed never deployed the tool as the virus triggered a recession.
Even as bond yields jumped through the COVID recovery, Fed officials have been lukewarm to the idea of using YCC.
Powell said on March 4 that “it’s always the case that if conditions do change materially, the committee is prepared to use the tools that it has to foster achievement of its goals.”