YCC – three powerful letters
A few years ago a new phrase entered the lexicon of fixed income markets and speeches made by central bank governors – yield curve control or YCC. As with many aspects of the modern world, the implications are profound – a structural change from how many of us grew up understanding financial markets.
Traditionally, the primary instrument used by central banks was setting short term interest rates – base or bank rate – in order to guide the decisions made by commercial banks and other financial institutions, businesses and consumers. Certainly, there was a degree of government debt management but mainly to ensure that financial markets were liquid.
That changed profoundly in September 2016 when the Bank of Japan carried out a major review of its policies. Its adoption of QE in 2013 and negative interest rates in early 2016 had not brought about the required normalisation of inflation, hence the move to include YCC in its armoury.
YCC means fine tuning along the whole fixed income curve in order to give incentives or dis-incentives to market participants. Rather than setting base rate and allowing investors and market makers to determine the shape of the yield curve, reflecting their views, for example, on future growth and inflation, debt dynamics and political developments, the central bank could exert its control all along the curve, whether shorter, medium or longer dated bonds. More technically, YCC shifts from a quantity target to an interest rate target for QE purchases. One outcome is less need for QE. Once market participants accept that the central bank will always take action to return a price or yield to the desired level, then normal buying and selling can bring this about. Japan’s QE purchases were closer to Y10 trillion in 2020 than over Y100 trillion in 2015-16.
In Japan’s case, the policy statement chose to target the benchmark 10-year Japanese Government Bond (JGB) yield at around 0 percent. By doing so it aimed to lower debt servicing costs for companies and households, while encouraging banks to search for higher profit opportunities rather than investing in government debt. The central bank can fine tune constantly. A few days ago Reuters reported that the Bank of Japan will alter its YCC purchases to allow JGB yields to edge higher. The 20-year bond yield has moved towards 0.25%.
Japan is not alone in using this technique. Australia adopted YCC in March 2020, in response to the coronavirus, targeting a three-year government bond yield of 0.25 percent. Prior to the COVID-19 crisis, names such as Bernanke, Brainard, Clarida and Yellen all said that the Fed ought to consider adopting YCC when short term rates fall to zero. Such a rate peg could be an effective complement to forward guidance and QE, two policies that are already firmly part of the Fed’s toolkit. Some analysts suggest that India’s central bank has been using a form of yield-curve control since February 2020.
Even where a policy has not been announced then it may appear in practice. Bloomberg recently reported that the ECB is operating a “yield spread control” approach between the bonds of different members of the EMU. This involves buying bonds to limit the difference in yields between the strongest and weakest members. Last year, the ECB purchased 100% or more of the government debt issued in the peripheral economies Greece, Ireland, Italy, Portugal and Spain. This approach might explain why the spread between Italian and German debt stayed remarkably stable despite the Italian government nearing collapse.
What does this mean for the UK markets? Domestically, YCC is not yet definitely on the agenda. According to Governor Andrew Bailey last November, the Bank of England has discussed using yield curve control in its search for new ways of boosting its firepower, but there is little need for it at the moment: “we’re talking about all the tools that could possibly be in the box”. Japan’s experience suggests that YCC could be introduced if the Bank becomes concerned about the size of its balance sheet or as a means of preventing longer dated bonds moving higher too quickly. Meanwhile global capital flows in fixed income markets mean that UK yields will always respond to buying, selling and price setting in other countries. Gilts can be seen as caught in a tug of war between the low yields prevalent in Japan and Europe and the higher yields of US markets.
YCC is a fundamental change in how far central banks interact with financial markets, not just price setting in short term money markets but across a much wider array of fixed income assets. In theory it allows policy makers to target bond yields at levels it considers appropriate given the prevailing economic conditions without significant expansion of its balance sheet. A counter-argument from some economists is that through setting the price of capital other than where it would naturally be, the central bank is misallocating, and therefore destroying, capital. Exiting from YCC might be associated with large capital losses, not just for central bank balance sheets but also other indebted parts of the economy. Desperate times call for desperate measures, but skilful communication and forward guidance will need to be the order of the day.
Andrew Milligan is an independent economist and investment consultant. This note should be considered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making