What is yield curve control, and what happened today in Japan?

Japan jolted the market Tuesday morning with a surprise tweak to its yield curve control strategy. This pumped the Yen against the dollar (USD/JPY), and sent waves throughout the market, with S&P 500 futures sent sharply lower. But what does yield curve control mean?

Most central banks do not use yield curve control

The US Federal Reserve typically manages economic growth and inflation through the setting of a key short-term interest rate known as the federal funds rate. This is the rate that the market watches so closely, as it governs how cheap money is to borrow, which has knock-on implications for the economy at large.

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This year, inflation has risen rapidly across the globe which has led to central banks aggressively hiking rates, in order to quell demand and cool the economy down, the most recent of which was a 50 bps (0.5%) hike last week.

The above graph shows that interest rates have come down to near-zero frequently over the last twenty years. Thus, the central bank’s ability to influence economic growth is limited because it can no longer cut rates.

Moreover, the Fed funds rate is the short-term rate for things like credit card debt and car loans. While the rate filters through the economy, it may want to affect the long-term interest rate directly, which is essential for things like mortgage rates.

To achieve this, the central bank engages in the purchasing of securities and government-backed debt on the open market, which injects bank reserves into the economy. This is known as quantitative easing, and keeps the financial system awash with credit. It’s the music they play to keep the party going, in other words.

How is quantitative easing different from yield curve control?

But one country is different – Japan. Its central bank, the Bank of Japan (BoJ) has employed a different strategy known as yield curve control since 2016. This is a more unconventional way of keeping yields at a certain level, and targets the long-term yields.

Yield curve control involves a central bank buying or selling as many bonds as necessary in order to target a specific longer-term interest rate. This may sound similar to quantitative easing, you say. And you’re right, it really is. They are two sides of the same coin – they bought involve purchasing of government debt (treasuries) to affect interest rates and pump money into the economy.

But the difference is, quantitative easing involves the purchasing of a specific amount of bonds on a regular basis in order to inject this credit into the system. Whereas yield curve control involves purchasing as many bonds as necessary in order to keep yields to a certain level.

So, quantitative easing is focused on the quantity of money, whereas yield curve control is all about targeting a specific long-term yield.  And yield curve control is typically focused on long-term yields rather than short-term.

What is happening in Japan with yield curve control?

In the case of Japan, the BoJ shifted to a yield curve control policy in 2016 which sought to peg the 10-year Japanese government bond (JGB) yield to 0%. This means that whenever the JGB yield rises above 0%, the BoJ purchases bonds to drive the yield back down.

Advocates of this policy argue that central banks can achieve a lower interest rate with a much small balance sheet than they could under quantitative easing.

The trade-off is that bond trading can drastically slow down. Companies can also be incentivised to load up on debt, allowing zombie companies to roll on simply by rolling over cheap debt. There is also the problem of bigger companies likely being able to take advantage of this lower rates to a grater degree, throwing up all sorts of monopoly implications.  

Critics also affirm that inflation expectations rise. But the main drawback could be the uncertainty, as nobody really knows what the policy will impact in the long-run. The Federal Reserve did pursue yield curve control since World War II, but it has not been used since in a normal time period.  

What happened today?

This morning, the Bank of Japan caught markets off guard by widening its target on the 10-year JGB to allow it to move 50 bps either side of 0%. It said in a statement that it was intended to “improve market functioning and encourage a smoother formation of the entire yield curve, while maintaining accommodative financial conditions”.

The Yen strengthen as a result, as higher yields mean more capital is likely to flow in. Stocks in both the US and Europe peeled back ahead of opening bell. The market is likely viewing this as a signal that Japan is guarding itself against inflation.

With Japan turning more hawkish, the adamant stance of the Fed this week that high rates would persist, and ECB head Christine Lagarde also warning of higher rates, the market continues to realise that 2023 may be a high-interest environment for longer than previously anticipated.  

Strap in people, a return of the easy-money days are a long way off yet.