Macro Digest: Don't put all your eggs in the yield curve control basket just yet
Comment of the Day

March 04 2021

Commentary by Eoin Treacy

Macro Digest: Don't put all your eggs in the yield curve control basket just yet

Thanks to a subscriber for this note by Steen Jakobsen for Saxo Bank. Here is a section:

3. The Fed wants the yield curve to steepen – it is better for credit provision and banks, who borrow short and lend long, and most of the funding for the US government happens is done at 0-3 years, the most important part of the yield curve. The 10-year plus long end is not a major concern as long as the short-end is anchored

4. Chaos at the short-end of the yield curve. The running down of the Treasury’s funds held at the Fed (built up to more than $1.6 trillion during the pandemic emergency) has created dysfunction in the repo market and at the very shortest end of the US yield curve, where rates have dipped below zero at times for the repo. The fault for this lies with the inexperienced New York Fed President Williams, who needs to be replaced. Some believe that the situation can be addressed with a new “Operation Twist” in which the Fed sells some of its shorter maturity holdings to buy at the longer end. But this does the exact same thing as YCC and would set a precedent the Fed won’t want to set. Another fix, a raising of the bank deposit limit would also have two major consequences: the Congress don’t want to "weaken" banks’ balance sheets, and why would Jamie Dimon and other bank CEOs want to be burdened with more US debt if the Fed is going to cap the yields on that debt?

Yes, the troubles in the plumbing at the short-end of the yield curve will trigger some sort of Fed action, but expect a very technical support for the short-end that raises liquidity and the shortest rates away from zero.

If the Fed were to do yield-curve-control YCC, it will be further down the road and likely not extend beyond the 3-year treasury rate, as opposed to market expectations of up to 10Y. The Fed may support the fiscal handover at the margin when we have yet to get to the other side of vaccinations and with unemployment and underemployment at current levels, but they will not entirely throw in the towel on allowing the market the ability to reign in overspending governments.

Of course, one wonders if it is already far too late for the Fed to think this way – given where US budget deficits are headed and the needed treasury issuance to cover those deficits, but at least we need to acknowledge the modus operandi of the Fed.

Eoin Treacy's view

Economic data is probably going to be loopy for at least another six months. The massive one-time economic contraction in global economic activity has skewed all manner of economic comparisons with past cycles.

Negative oil prices, surging savings and outsized wage growth amid record high unemployment tell us little more than there was a big shock to the system. In five years, these will look like data aberrations, but today we are creeping up on when year over year comparisons will be most affected. Making bold predictions about the output gap or economic potential against that background is fraught with risk. I prefer instead to focus on objective facts.

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