In focus

The return of “Operation Twist”: will the Fed flatten the yield curve again?


Investors’ expectations for both substantial fiscal stimulus and subsequent inflation have grown recently. Bond yields have risen too, most notably in late February when Treasury yields lurched higher as investors seemed to entertain the possibility of monetary policy tightening.

This to some degree raises the spectre of the 2013 Taper Tantrum, when markets panicked as quantitative easing was reduced. One analyst dubbed the recent episode “a tantrum without the taper”.

However, we think with these latest developments, the market is somewhat wide of the mark. Given the scale of outstanding debt, it is necessary for rates to stay low, while the Federal Reserve (Fed) and other central banks have plenty of other tools to keep them that way if needed.

The Fed’s monetary toolkit

While the Fed is unable to explicitly control the long-end of the Treasury curve, it has many mechanisms at its disposal to exert influence and limit any rises in long-end nominal yields. These include: public and private sector intervention, inflation targeting and regulation. 

The Fed used a variety of these tools the last time we had public sector debt burdens at comparable levels, back in the 1940s in the aftermath of World War Two. During this period, the Fed successfully kept real interest rates (government yields minus inflation expectations) negative for a prolonged period, while inflation was allowed to rise to manage the real debt burden lower. It is likely this is the environment we will now be in for the foreseeable future.

  • Monetary intervention

Direct monetary intervention can include implicit or explicit caps on interest rates, including yield curve targets, control of cross border capital flows or regulatory changes forcing banks or saving institutions to hold more Treasury securities. All of these happened to a certain degree in the post World War Two era.

  • Yield curve control

Yield curve control is the most obvious mechanism to control rates. Unlike quantitative easing, which focuses on buying a certain amount of bonds, yield curve control seeks to set an explicit target or yield cap on longer maturity bonds. The Bank of Japan has been doing this successfully since 2016 when it set a target of around 0% for the 10-year yield. Australia has a target of 0.25% for three-year bonds. The Fed also did this in the 1940s when it set a 2.5% target for long-dated treasuries.

  • Operation Twist part 2

Extending the maturity of bond purchases is also an option to control yields. This is a version of the “ Operation Twist” that we saw following the 2008 Global Financial Crisis.

A great example of that came this week from the Reserve Bank of Australia who set a new high water mark, buying $4 billion of long-dated bonds in a single day. This move resulted in  Australia’s 10-year rate falling 25 basis points (bps) to 1.65%  in one day.

  • Regulation

Another method to keep yields low would be to pass legislation to force savings institutions from banks, insurers or pension funds to buy more Treasuries. This already happens to a certain extent with pension funds being discounted at longer-term bond yields and banks being forced to hold certain high quality instruments for regulatory purposes.

  • Managing expectations

The Fed can also alter market expectations, and therefore term premium (extra yield required by investors to hold longer-dated bonds), by changing its inflation targets. Indeed, in August, it moved to an “average inflation targeting” regime, whereby it looks to target an average of 2% inflation over a cycle. This acted to steepen the US yield curve. The Fed could reverse this decision, or lower the average inflation target if it wanted to flatten the curve once again.

Low rates remain imperative for policymakers

The bottom line is that in a truly free market it is likely interest rates would be higher. But we no longer operate in a truly open market. Given the magnitude of debt, both in the US and globally, authorities will likely continue to intervene in markets if rates rise too high.

In the 1940s, 1950s and 1960s, while interest rates remained contained, we saw negative real returns on bonds. We may see a similar dynamic in the coming years. After all, keeping rates low while allowing inflation to rise is the most effective method for authorities to manage down current debt burdens.

 

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