NO. 6 ∙ June 2020
Endless purchase programmes?
AUTHOR: Dr. Volker Schmidt
Senior Portfolio Manager
The central banks are using ever-larger purchase programmes to tackle the recession caused by the COVID-19 pandemic and the upheaval in the capital markets. Central bank balance sheets are continuing to record new highs. But is all this purchasing really necessary? Do the central banks actually have a plan to extricate themselves from constant programme expansion? One option would be to gain control over the yield curve instead of investing large amounts in buying up bonds, as has been the case. With this policy, the central banks not only determine their short-term interest rates, as set administratively through their current interest rate policy, but also try to limit yields on the sovereign bond curve.
Examples of this can be found in Japan, Australia, and in the U.S. Back in 2016, the Japanese central bank (the Bank of Japan) shifted its policy from purchase programmes to yield curve control. The key rate at which the central bank pays interest on commercial bank deposits was set at -0.1%. In addition, it aims to keep the Japanese 10-year sovereign bond yield in a narrow range between -0.2% and +0.2%. The Australian central bank also began to take similar measures in March of this year. The interbank overnight rate was lowered to 0.25%. At the same time, the central bank is striving to limit the yield on Australian three-year sovereign bonds to 0.25%, and is supporting this by making purchases on the secondary market. In this way, it is trying to keep the cost of refinancing down for the whole economy. The Federal Reserve in the U.S. has also had experience with this kind of interest rate policy in the past. In the 1940s, it controlled the entire U.S. Treasuries yield curve and thereby helped the government to keep the cost of financing the war effort down.
Yield curve control: the wiser policy choice?
Of course, effective yield curve control requires that the central bank has sufficient funds to be able to implement such a policy convincingly. In Japan, for example, since yield curve control was introduced by the Bank of Japan in Autumn 2019, the yield has fallen below the target range only once for a short time. Since the majority of Japanese 10-year sovereign bonds are now held by the Bank of Japan (88% according to HSBC’s calculations), there is no doubt that it is indeed capable of effectively controlling the interest rates. If yields fall too far, they can reduce their own holdings. Conversely, pressure to sell is unlikely ever to get so great that massive interventions in the market would be required. The fact that the Bank of Japan is purchasing sovereign bonds to a much lesser extent than other central banks during the current crisis has also recently often been cited as another benefit of yield curve control. Monthly purchases have fallen from almost JPY 10 trillion in 2016 to approximately JPY 5 trillion at the moment. The reason for this is that in the past four years the Bank of Japan has already bought its own sovereign bonds on a large scale, and is able to control (not to mention manipulate) the yield curve at will. In order to keep yields at the desired level it is therefore no longer necessary to continue to spend large sums of money.
Of course, this central bank policy also raises questions concerning sustainability and longer-term implications. Does it really create a further incentive for companies to invest? Can we expect higher inflation or even a reduction of national debt? Japan has shown us that this policy enables the Japanese government to raise money cheaply and thus support consumption or investment. In addition, it has not led to a rise in inflation or a reduction of national debt in Japan so far. On the other hand, it is only possible to exit this policy if investors are prepared to buy these bonds back off the Bank of Japan. At the current yield level, this can really only happen by compulsion or because the alternatives are even more unattractive.
A study from this year by the New York Fed examines the yield curve control by the Federal Reserve in conjunction with the Department of the Treasury from 1940 to 1945. At that time, the rates for Treasury Bills with a maturity of 13 weeks up to 30-year Treasuries were fixed and always kept below the set value by means of purchases and sales. In particular, this study examines whether fixing a rising yield curve was the correct choice at the time or if a flat yield curve would have been a better choice. In addition, it discusses how best to exit this policy. Whatever conclusions the Fed draws from this study for its future interest rate policy, one thing is clear: today, too, the Federal Reserve would certainly have no difficulties controlling the long end of the yield curve. In the first four months of this year, around USD 200 billion was issued in U.S. Treasuries with a maturity of 10 years or more. However, the Fed has already purchased more than USD 1.5 trillion in U.S. Treasuries since March alone. If they focus their purchases specifically on the long end of the curve it should be easy to control any rise in yields.
Yield curve control: not a magic bullet!
Yield curve control can only be successful if the central bank is permitted to buy up any amount of sovereign bonds and has sufficient bonds to sell them again if there is a likelihood that yields will fall. Therefore, yield curve control is only possible if large-scale purchases were made beforehand. This gives central banks slightly more flexibility and allows them to suspend their purchases during times of strong investor demand, meaning they do not have to stick rigidly to the schedule and volume of their programmes. Ultimately, both the purchase programmes and yield curve control aim to facilitate the refinancing of growing government deficits at tolerable interest rates. If national deficits rose further even yield curve control could not avoid further purchases. So, it is not a true alternative.