On Saturday, Joe Biden’s big stimulus package cleared its first major political hurdle. The US House of Representatives gave the go-ahead to the $1.9trn coronavirus relief package. It now needs to get passed the Senate. The US has already spent 16.7% of GDP on measures to help the economy, notes Capital Economics. This would push it up to as much as 25%. That’s way bigger than in the eurozone, for example. It’s small wonder that investors are starting to worry about inflation.
As Neil Shearing of Capital Economics points out, not only is fiscal stimulus bigger in the US, the “degree of economic slack” is probably smaller than in the eurozone too. So you’ve got a big demand hit coming, and supply isn’t necessarily there to handle it. So you can see why bond investors are a bit rattled.
“Bonds are not the place to be these days”
Markets have calmed down somewhat this morning, but there’s every chance that it’s just a bit of calm before the next panic. None other than Warren Buffett provided a bit of perspective in his latest annual letter at the weekend, and it wasn’t comforting: “Bonds are not the place to be these days. Can you believe that the income recently available from a ten-year US Treasury bond – the yield was 0.93% at year-end – had fallen 94% from the 15.8% yield available in September 1981?”
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That shows how long this trend has been running for. It also gives you some sort of idea of how disruptive it might be when it reverses. However, it’s also why we shouldn’t assume that central banks will take it lying down.
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Some notable action has been taking place in a market that most of us don’t often pay much attention to – the Australian government bond market. The Reserve Bank of Australia today “doubled down on bond purchases”, as Bloomberg reports. The central bank decided to buy more than $3bn-worth of longer-dated Aussie government bonds. That followed on from a burst of extra spending at the end of last week.
What does all that mean? The Australian central bank is telling markets that it won’t allow interest rates to go up too quickly or by too much. This is what’s known as “yield curve control” or YCC, and it’s an acronym you should probably get familiar with, because you’re going to see a lot more of it in the next few months, all over the world.
Yield curve control is likely to spread
In the old days (pre-2008, or GFC (global financial crisis) Year Zero as we may one day rebrand it), central banks focused on setting short-term interest rates. Long-term ones (in other words, government bond yields) were allowed to please themselves, and served as useful indicators of market expectations. Gradually, in the post-GFC era, central banks started to control interest rates further and further into the future, using quantitative easing (QE) to buy longer-dated government bonds. YCC is the next logical step. It’s something the Bank of Japan has already been doing for a long time.
The big difference between YCC and quantitative easing (QE) is this: with QE, the central bank says it will spend a certain amount of money on bonds. Driving down interest rates on the bonds is part of the process, but there is no explicit target. With YCC, the central bank specifically says that it wants interest rates (in other words, bond prices) to stay at a certain level, and that it will buy (or sell) as many bonds as necessary in order to get to that level.
Several central banks have already started doing this. In 2016, for example, the Bank of Japan (BoJ) decided to use YCC to keep the yield on the ten-year Japanese government bond at around 0%. It has worked, in that investors realise the BoJ is serious, and therefore don’t try to test its resolve by pushing out of the 0% area. In turn, that means the BoJ hasn’t had to buy as many bonds as it might otherwise have done using QE. Meanwhile, in March, as central banks reacted to the coronavirus going global, Australia adopted a more limited form of YCC, targeting an interest rate of 0.25% on three-year bonds.
Both the Federal Reserve and the Bank of England have treated the recent surge in yields as more of a healthy correction. That’s not necessarily a bad idea, given that yields are only now back to where they were just before the pandemic upturned everything. You could argue that in effect, we’re only back to “normal”. But of course, it’s “normal” plus a load of economic damage plus a load of government spending that we wouldn’t otherwise have had. I suspect that it’s only a matter of time before investors start to push against this apparent comfort zone.
I’ll be interested to see how long the apparent insouciance lasts before the Fed gets on board with its Australian and Japanese peers. Once it becomes clear that interest rates will be held down artificially, that’s when the inflation trades will really start to take off.
We’ll have more on this in the coming issues of MoneyWeek magazine. If you’re not already a subscriber, get your first six issues free here (plus a special free bonus downloadable report on bitcoin).
