David Gracey

David Gracey

Head of Foreign Exchange and Fixed Income Trading

Yield curve control - The new jargon

·        Every now and again new terminology is introduced into the plethora of available financial jargon.

·        The latest terminology that we now have to get used to is “YCC”, or more specifically -  “yield curve control”. This is where Central Banks actively attempt to control the longer end of a particular countries yield curve.

·        For decades Central Banks have controlled money supply through the raising and decreasing of short-term interest rates.

·        Very simplistically, as inflation rises, CB’s raise rates, thereby making debt more expensive in an attempt to limit money supply, and as inflation declines, they do the opposite. This kind of activity would have an impact on the price of longer-term debt as market forces decided the shape of an economies yield curve.

·        Then 2007-2008 happened and Major CB’s turned to Quantitative easing – the act of buying up longer-term debt in an effort to drive longer-term rates lower, even as short term rates were cut to zero, or below. This meant that CB balance sheet sizes exploded as assets on the books ballooned through this activity. This meant that governments could borrow cheap money from the Central Bank, thereby incrementally increasing the debt supply, and money being pumped into the economy.

·        Economics 101 teaches us that as more debt is introduced (supply), the price of that debt should get more expensive (higher rates). However, with Central Banks acting as a backstop (buying up this debt) longer rates actually declined, in some cases moving into negative territory.

·        The theory being here that as all this money moved into the economy, the activity would rise, leading to stronger economic growth, leading to higher tax revenues, thereby paying down the debt. IN THEORY.

·        In reality, what we have seen over the last decade and a half, is that debt has increased, and economies have shown anemic growth.

·        So we have a situation (again in very simplistic terms) where short term rates are at historic lows (negative in many instances), GDP growth is anemic, Government debt across the world is at historic highs, and CB balance sheets are as inflated as my belly after a decent Sunday afternoon braai.

·        And then Covid happened. Meaning that this playbook was rolled out again.

·        If we look at the example of the U.S – The Federal Government added almost 20% to its debt burden IN 1 CALENDAR YEAR.

·        Gross national debt rose from +- 23 TRILLION USD, to +- 27 TRILLION.

·        “There ain't no such thing as a free lunch” is a saying that is well used in economic circles. Basically, it means that eventually, everything had to be paid for.

·        Inevitably longer-term rates eventually start to discount this eventuality. Pay the piper ….rates begin to rise, even as short-term rates remain pinned at low levels. Investors demand higher yields for the risks associated with investing in longer-term debt.

·        In the case of the U.S, 10-year yields have climbed by roughly 150% (90 basis points) in a few months. Causing a fair amount of volatility in financial markets. And costing the Government far more in refinancing charges, on a ballooning debt pile.

·        Enter YCC – essentially an act of making sure that longer-term rates stop climbing. Targeted yield curve management. Nothing more than more QE, but “targeted.”

·        An attempt to halt the piper leading us all over a cliff of financial largesse.

·        It does not take a genius to see where this is all headed. History has many examples that we can learn from.

·         But Central Banks will hold back the tide (or try). But at some point, the lunch will have to be paid for.

·        In the meantime, this liquidity finds its way into riskier assets. The printing press needs to run and money will find a home.

·        In the longer term, my fear factor is rising all the time.

·        Bitcoin anyone?