Fed minutes reveal more debate on capping bond yields

Bond managers positioned for the Federal Reserve to revive a radical policy targeting bond yields were left disappointed on Wednesday, after minutes from the US central bank’s most recent meeting showed officials were still debating the benefits of so-called yield curve control.

The minutes of the early-June meeting prompted selling of two and three-year Treasuries, reversing buying seen at the start of the week. Investors and analysts had ascribed the recent rally to a growing likelihood that the Fed would follow the Bank of Japan and Reserve Bank of Australia and set upper limits for certain Treasury yields. The central bank then buys or sells as many government bonds as needed to maintain those levels, in an effort to keep a firm lid on the cost of borrowing.

The Fed has used already several of the tools at its disposal to cushion the blow from coronavirus, with deep interest rate cuts and pledges to buy a wide range of debt instruments. At issue is what the Fed might do if the economy needs a further jolt, especially given that it has ruled out a move to negative interest rates.

“After reviewing the minutes, I feel like it is not at the top of the list of what the Fed is looking to do,” said Deepak Puri, chief investment officer at Deutsche Bank Wealth Management. “But I wouldn’t be surprised if the bond market just forces the Fed to have some kind of yield curve control before the end of the year.”

The minutes indicated Fed officials were undecided on the policy, which was last used in the US during the Second World War. Some officials said it “could serve as a powerful commitment device”, while others flagged concerns about how to implement it.

Line chart of Yield on US Treasuries, by maturity (%) showing A blip. But still the biggest rise in US Treasury yields in nearly three weeks

However, the officials did say Australia’s approach of targeting three-year government yields was seen as “most relevant” to the current backdrop in the US, and that “all participants” wanted to see further analysis of yield curve control.

David Norris, head of US credit at TwentyFour Asset Management, said the fact that yield curve control was being discussed at length was a sign it was under serious consideration. “Where there is smoke, there’s fire,” he said.

While James Sweeney, chief investment officer for the Americas at Credit Suisse, considers yield curve control a “drastic” policy, he said it would be a powerful tool for the Fed to have in its back pocket.

“If you are really looking for a bazooka that changes things, yield curve control is that,” he said, adding that such a policy is likely to come after the Fed rolls out a more explicit form of forward guidance.

Doubts remain over its efficacy, however. Subadra Rajappa, head of US rates strategy at Société Générale, questioned what more yield curve control could achieve, given rates remain near historic lows.

Bond managers have for months sought the relative safety of low-yielding Treasuries even as economic data has improved. Some have done so in the anticipation of further Fed intervention, while others worried the economy would struggle out of recession. Haider Ali, the head of US Treasury trading at RBC Capital Markets, noted that “most domestic fixed income managers are still not as optimistic” as the rebound in stocks might imply.

Wednesday’s minutes prompted the yield on two- and three-year notes to climb just over 0.01 per cent — a small move by historical standards but nonetheless the biggest rise in almost three weeks, given strong buying recently. Five-year Treasury notes also sold off for a second day, lifting the yield 0.05 percentage points higher from a record low of 0.26 per cent hit on Monday.

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