Yield Curve Control Blues

The Bank of Japan surprised people with a change to its yield curve control (YCC) policy. This has caused a mild sell-off in Japanese bonds, with the 10-year Japanese Government Bond (JGB) yield up 15 basis points on the month when I last checked.

Although I think some of the usual suspects have tried to get excited about this — a harbinger of doom to Japan and/or the global fixed income complex! — this is still in nothingburger territory. (Note: people who discuss bond yield changes as a percentage of previous yields — e.g., “bond yields rose by 100%!” when the yields go to 0.2% from 0.1% — are innumerate clowns and are safe to ignore.) Nevertheless, if the yield cap was raised by a lot more, there would be a lot of wailing and gnashing of teeth.

One standard dodge of a forecaster is to say that this might be important for global bonds. This makes one sound like a very serious forecaster with an eye on those darned black swans. However, any number of things can cause global bond yields to rise. If you want to be a yield forecaster (I don’t!), at some point you have to put your money where your mouth is and either recommend long/short positions and/or option strategies (if you want to position for tail risks). Although I am not a forecaster, I see no reason why I would change any non-Japanese market views as a result of these recent events.

Achilles Heel Of YCC

Yield curve control is a popular discussion point, particularly for Modern Monetary Theory types. My view is straightforward: yes, the government can make yield curve control stick. The problem with the policy is when the yield target is revised.

With short rate targeting, the central bank is not directly causing capital gains and losses for bond holders. Sure, they cause carnage, but they have plausible deniability: bond yields are set in the market, we are just setting the overnight rate! Sure, it’s stupid, but plausible deniability is still plausible deniability. On the other hand, with yield curve control, the central bank is directly handing out mark-to-market losses to widows, orphans, and pension fund bond managers. That’s a pretty potent political coalition burning you in effigy on the steps of the central bank’s main office.

It is also a financially unstable policy. A short-rate pegging regime works because forwards represent a market-clearing level in the private sector. Only an academic or central banker would be delusional enough to believe that central bankers can plant “expectations” where they want by announcing shifts to their views. In reality, the forwards represent the average guess as to how wrong the central bank’s forecast it. Once the central bank starts planting forwards by decree, market participants only have it a “take it or leave it” decision. If the forwards are too low, they dump bonds en masse — also known as an attack on the yield peg.

Needs Institutional Support

Anyone who has been paying attention to central banks has noticed several allegedly “permanent” self-imposed policy regimes by central banks over the past few decades (being a more detailed regime than the looser statutory inflation-targeting regime), each being abandoned whenever it became inconvenient. The lesson is that the only credible monetary policy regime is one that is backed by statute.

That is, the only way yield curve control is going to be a stable long-term policy is that it has to be set by law — and the rest of economic policy needs to be coherent with the policy. My view is that we are nowhere near a situation where policy is coherent with YCC, which is why I am not enthusiastic about the policy.