In recent months the Federal Reserve has unleashed battery of programs designed to support asset markets. To date they have been able to settle markets and the global economy using the same tools from the Financial Crisis, namely: cutting short term interest rates, large scale asset purchases, and reopening funding and liquidity facilities. The goal of these operations has been to stabilize short term funding markets, support the flow of credit to businesses, households, state and local governments and to reinforce expectations that the Fed will do “whatever it takes”.
As the economy moves past the initial meltdown phase and into the period of protracted recovery, very substantial uncertainty remains concerning the pace and strength of the rebound. Many (including the Fed) are very skeptical about the prospects for a V (if we must ascribe a letter to it) shaped recovery. In particular, they express concern about persistent deflation, structural unemployment and a slow return to full capacity growth (see June 2020 Projections).
Rightly or wrongly, increased Fed involvement (and indeed the fixation on increased Fed involvement) is going to be a major feature of financial markets for the foreseeable future. Therefore, as investors, it behooves us to understand what policy alternatives are under consideration and what they could mean for our portfolios.
There has been much discussion about what tools the Fed has left in its toolbox should it need to deploy additional stimulus. The most interesting among the options remaining involves targeting longer term rates via “yield curve control”. In this post, I’ll discuss the mechanics of yield curve control (YCC), the historical track record and what it might mean for stocks.
Let’s do it!
Mechanics of Yield Curve Control
Historically, the Fed’s main policy tool has been influencing short-term rates via setting the discount rate and open market operations. The Great Financial Crisis demonstrated the limits of simple interest rate policy and resulted in a significant expansion of the Fed’ monetary policy tools in order to stimulate the economy. Key among these new tools, Quantitative Easing sought to purchase a wider range of Treasury maturities in an effort to push down long-term rates. The belief was that by purchasing a large quantity of Treasuries, the Fed could force rates down across the curve. Given that Treasury rates are an essential benchmark for pricing other financial assets, this action would promote ample and available credit and lower the overall costs of financing.
As the fallout from coronavirus continues the discussion has turned to other techniques the Fed could employ to aid the recovery. One policy under active investigation is Yield Curve Control (YCC). Yield Curve Control is related to quantitative easing in that both are aimed at influencing longer term rates and potentially involve the purchase of large volumes of securities. However, the posture of the policies is quite different: one sets a quantity while one sets a price. With QE, the central bank sets an amount of securities to purchase but does not determine prices and yields. In contrast, Yield Curve Control sets an explicit target for Treasury rates and purchases whatever amount of securities is required to peg the market rate to the target.
In this way, QE and YCC can act as complementary policies. QE is less precise as the effect on rates is unknown beforehand but gives the Fed substantial flexibility to operate across the curve. Conversely, YCC has a very precise effect on interest rates, but must be highly targeted to be feasible.
The success of a yield curve control campaign will depend in large measure on the credibility of the Fed. If investors do not believe that the Fed can consistently set long term rates or fear they will lose control of inflation, then they will sell their holdings. Under such a scenario, it’s conceivable that the Fed would have to buy very large quantities of securities at the targeted maturity (possibly almost all outstanding) in order to achieve its objective. Conversely, if the statement is found to be highly credible, then rates may adjust in the open market based on the statement alone. A credible statement may allow the Fed to achieve its objective without having to purchase securities at all.
To establish credibility, it’s likely that the Fed would begin with a modest goal for rates at relatively short maturities. Short term bonds are much less sensitive to changes in economic data than longer dated maturities. The reason being that it is easier to develop expectations about short term economic performance. For these reasons the Fed would likely adopt a narrow policy that targets a single maturity with a short duration. An example of such a target might be the 2-year Note. Setting a target for a longer maturity, such as the 10-year, would present challenges as economic information that comes out over the period may significantly alter the path of rates which could destabilize the peg. In such a situation the Fed may be forced to buy huge quantities of bonds and the effect of the policy may be lost entirely.
Short term rates already have an impact on longer term rates if the market can effectively price the information. It is quite likely that pegging a short maturity would produce the desired effect of reducing rates further out on the curve. Furthermore, the Fed is likely (and rightly) concerned about significantly distorting markets. The short end of the curve is Fed territory and the long end belongs to the market. In order to maintain a comfortable degree of yield curve “steepness” (and consequently positive term premiums) they would be hesitant to move too far out the curve. You can easily imagine a situation where the Fed tries to peg the 10-Year Treasury rate only to have other sections of the curve invert and become terribly distorted. This would necessitate pegged other rates on the curve to correct the distortion and require vast quantities of purchases. In the end they could lose control of the balance sheet and then we’d have a real problem.
History of Yield Curve Control
Now that we have some sense of how the Fed might approach a policy of YCC we can turn to history to see how such policies have worked in practice.
Case 1: United States – 1942
In the US, Yield Curve Control has actually been employed once before. In April 1942 the Fed embarked on YCC in an effort to help the Treasury finance US involvement in World War II. After a series of negotiations with the Treasury, the Fed agreed to peg the T-bill yield at .375% and to cap the long-term yields at 2.5%. The result was a yield curve that was both low and relatively steep.
Curiously, the Fed never formally announced this policy; evidently fearing that it would stoke inflation expectations that could jeopardize the program. Still, investors apparently found the program credible and sold Treasury securities to the Fed at the fixed prices. The Fed was initially required to purchase about $20B in Treasury bonds (which, at the time, was ~10% of the outstanding debt), but after 1942 little intervention was required. The demand for Treasuries remained sufficiently strong and yields stayed low. The program was quite effective in helping to finance the war and surprisingly efficient.
Case 2: Japan – 2016
The results of the Japanese experience with yield curve control are a bit less clear. To begin, the reasons why the Bank of Japan (BOJ) has adopted a YCC policy are quite different from the US case discussed above. The Japanese economy has been plagued by slow growth and deflation for the better part of two decades. Their economy was hit very hard by the 2008 Financial Crisis and in many ways they have never been able to dig themselves out.
Like the US, the BOJ embarked on a program of quantitative easing in 2013 and bought enormous quantities of bonds in an effort to raise inflation to its 2% target and reinvigorate the economy. However, it quickly became clear that the policy was unsustainable. At one point the BOJ owned 40% of the government bond market and inflation still hadn’t budged. Thus in 2016, the BOJ announced the tongue twisting policy of Quantitative and Qualitative Easing with Yield Curve Control (QQE with YCC). Under this new framework, the BOJ committed to keeping the 10-year yield at 0% until inflation was running consistently at 2%.
In some ways the policy has been very efficient as it has substantially reduced the need for the BOJ to purchase securities outright. As the below graph illustrates, the pace of asset purchases declined significantly following the BOJ’s announcement. They are still employing QE, but in a manner than is much easier to manage.
However, the policy has done little to actually achieve the stated goal of 2% inflation. As the below graph illustrates, inflation in Japan continues to hover around 0%. Pair this with the disruption caused by COVID-19 and it’s likely that the Japanese economy will continue to be faced with slow growth and declining inflation expectations for many years to come.
For a detailed history of recent Japanese monetary policy, check out this post from the New York Fed.
Yield Curve Control: Implications for Portfolios
In my opinion, there are two potential channels through which YCC could impact stocks. The first is through company fundamentals and how yield curve control filters down into the real economy. The other focuses on investors and market fundamentals.
1) Lower Financing Costs
Lower cost of financing would be beneficial for companies with significant leverage, those that are capital intensive, or industry “disruptors”. Industries such as real estate (where debt is essential) should see their cash flows improve and values rise as YCC should help bring down their cost of debt service. Sectors that are capital intensive like autos, aerospace and other industrial goods should be able to finance capital expenditures and invest in improving processes, operations and products, which should support growth in the long run. Disruptors present a uniquely interesting case.
The term “disruptor” came about in the 2010’s to describe highly innovative business models that capitalized on the low marginal costs of the internet to blow up the economics of established industries. Names like Uber and Netflix became ubiquitous with the disruptor ethos by charging head long into transportation and media (respectively). By building large customer bases very quickly, plowing under incumbents, and losing billions in the process disruptors have been able to unseat their legacy competitors to become dominate players.
My personal theory is that the low interest rate environment is directly responsible for the rise of the disruptor. Low interest rates bring down the hurdle for success: if you can access cheap financing, then you can effectively buy time until your business model works out. Uber is essentially just an app and manages to lose billions each quarter. In what world does this justify a $60B valuation? Answer: a low interest rate world. The disruptor business model is reliant on low rates and cheap debt until such massive economies of scale can be achieved that they reach profitability or develop a truly disruptive product like Uber is attempting to do with self-driving cars. YCC would serve to lock in financing and lower benchmark rates which should be highly constructive for disruptors.
2) Lower Discount Rates
The second mechanism is via discount rates. As I mention above, YCC should bring down the cost of financing. Lower cost of debt implies a lower cost of capital and a lower discount rate for investors. Going back to your undergrad finance, if we think of a stock’s price a summation of cash flows discounted at the Weighted Average Cost of Capital (WACC):
Then it is easy to see that, all else equal, a lower WACC (i.e. a smaller denominator) will increase the value of future cash flows (particularly those far out into the future) and result in a higher stock price.
Furthermore, this means that we should expect higher valuation multiples going forward. If discount rates are low, then each dollar of earnings (now or in the future) is more valuable to you today. If we consider P/E or P/B ratios then an increasing stock price, but consistent per share earnings or book values necessarily means that valuations must go up.
Assuming the Corona Crisis does not significantly alter the path of long-term earnings growth, then we can expect multiple expansion to occur broadly across markets. Specifically, aggressive growth stocks would be key beneficiaries as their expected cash flows will be realized well into the future.
Effect of Yield Curve Control on Stocks: Historical Evidence
Having described how YCC might impact stocks in theory, we can once more turn to history as a guide to see how things have played out in practice. As mentioned previously, we only have two instances where YCC has been employed to aid us in developing our view on stocks: the US from 1942-1951 and Japan 2016-present.
Case 1: US 1942-1951
In order to build rigor into my theory of multiple expansion under Yield Curve Control, I examine P/E ratios over the period 1942-1951 for the S&P 500. The data used in the analysis comes from Robert Shiller’s data archive which you are free to download. I quote both a simple Trailing 12-month (TTM) P/E as well as Bob’s Cyclically Adjusted P/E (CAPE) Ratio in an effort to incorporate multiple valuation techniques. The below graph highlights the main results.
You’ll have to forgive me for the aesthetics of the plot. The data used is based on monthly price and earnings data, but earnings only come out quarterly. To correct for this, Bob’s data linearly interpolates the earnings to generate monthly figures. Hence you observe jumps in the graphs of both the Simple P/E and CAPE coinciding with new earnings releases.
The Federal Reserve began conducting de facto YCC beginning in April 1942. At this time the Simple P/E and CAPE of the S&P were 7.69 and 8.54, respectively. We immediately observe a very pronounced increase in both ratios taking place through 1946. The Simple P/E topped out at 22.12 and the CAPE rose to 15.77. In both cases, this represents substantial multiple expansion and impressive returns for stocks which posted annualized returns of 16.83% over 1942-1945.
The latter half of the analysis period in a bit murkier. We observe an equally large collapse in both ratios after 1946 coinciding with a period of struggle for the S&P. However, this might have had little to do with the yield curve control policy. 1946 marked the true conclusion of the war in both European and Pacific theatres and brought about the end of war time price controls. As a result, the US went through a period of wild inflation (see below). Furthermore, the falloff in government war time spending caused rolling recessions in both 1946 and 1949 which demonstrably set back the post-war recovery and corporate profitability.
Returns for the S&P were bifurcated during the 1942-1951, but still managed to post an annualized return of 9.47%.
| Overall Annualized | Annualized 1942-1945 | Annualized 1946-1951 |
| 9.47% | 16.83% | 4.81% |
Overall, this evidence suggests that Yield Curve Control coupled with considerable government spending was initially very constructive for stocks. Inflation and economic complications hurt returns in the latter half of the period, but, on balance, my theory of yield curve control igniting multiple expansion appears to hold up.
Case 2: Japan 2016-Present
My second case study comes by way of Japan which has employed YCC since 2016. In this more recent case, the evidence suggests a positive effect on Japanese stocks from the introduction of yield curve control. I lack reliable earnings and P/E data for the Japanese stock market, but the below graphs illustrate the main effects.
The first depicts the total assets of the BOJ against the Nikkei 225 (the primary Japanese stock market index). As I mentioned previously, in April 2013, the BOJ adopted a “shock and awe” strategy called Quantitative and Qualitative Easing (QQE) which committed the bank to increase the monetary base by ¥60-70 trillion per year via asset purchases. From the graph, we observe that the Nikkei tracked noticeably higher as the balance sheet expanded but began to lag in late 2015 and early 2016. Then, on the back of YCC introduced in September 2016, we observe the Nikkei reverse course and begin to climb higher before peaking in early 2018. Again, notice how the pace of growth of the balance sheet tapers beginning in 2016 as asset purchases are reduced but the effects of YCC drive the stock market higher.
The second graph illustrates the performance of the Nikkei against the S&P 500 beginning at the announcement of YCC in September 2016. We observe that the Nikkei significantly outperforms the S&P over the 2 years ending in 2018 despite the S&P itself performing quite well over this period. It should be noted that 2017 was a particularly good year for global stocks in general and particularly those of countries heavily exposed to a pick-up in international trade like Japan. However, it’s hard to argue that YCC held back the Japanese outperformance during this period given the Fed was raising rates in the US. The performance differential itself may be explained in large measure by the difference in the monetary stance between the two countries.
Conclusion
Yield Curve Control remains a relatively untested and highly controversial monetary policy tool. It’s important to remember that the objective of Yield Curve Control is to boost the broad economy and not just financial markets. So far, the outcomes have been mixed. Japan still struggles to generate sustained real growth let alone persistent 2% inflation despite its innovative monetary agenda. The impacts of coronavirus are only likely to exacerbate these trends.
The two cases available to us (both the US and Japan) almost certainly suffer from small sample bias and it very hard to prove meaningful causality under such circumstances. However, to the extent that Yield Curve Control produces any effect at all it seems most likely that we will observe it as a general rise in the price of financial assets. This implies that your stock portfolio may be a key beneficiary of YCC and this new era of monetary policy.
I hope you have found this post helpful. Until next time, thanks for reading!
-Aric Lux.
