The WSJ ( known as mouthpiece for Fed) wrote last week that “Fed officials are thinking hard about” yield curve control, or pegging various duration at certain levels.
It’s not clear from the article whether that’s conjecture, speculation or some kind of leak.
However there is a detail in the report that suggests this is beyond conjecture:
If the Fed concludes it is likely to hold rates near zero for at least three years, it could amplify this commitment by capping yields on every Treasury security that matures before June 2023.Another debate the article touches on is forward guidance and whether to tie it to the calendar or to economic outcomes.
Yield caps would be a natural complement to the calendar-based guidance but could be trickier to communicate if paired with outcome-based guidance.
Peter Garny of saxo banks writes
Yield-curve control has mixed results when it comes to equities. Japan’s YCC policy since September 2016 has not been a success judging from real GDP growth and for Japanese equities which have underperformed global equities. The period 1942-1951 when the Fed had a YCC policy in place suggests a more positive picture for equities against inflation hinting that YCC can work as a crisis tool.
However, the key risk related to YCC is inflation risk as our study of inflation and equity returns suggest inflation growth of 4% or higher leads to bad real rate returns for equities.
Which sectors will benefit from YCC?
The cap on long-term interest rates will also cap banks’ profitability through an upper bound on net interest margin. However, to the extend that YCC creates growth this will grow loan books and thus market values of banks. Our view is that financials should be avoided in this environment but that growth companies with a large part of their value coming from the future should be overweight as YCC creates a low discount factor for future cash flows.
Highly leveraged companies and capital intensive industries such as auto, airliners, steel, real estate, shipping, construction etc. should also outperform in this environment as YCC will set financing rates artificially low.
In nutshell you need to be with asset owners who will benefit from lower nominal value of debt and higher nominal value of assets
Inflation beyond a threshold in the danger to equities….
YCC combined with aggressive US government deficits could suddenly create inflation which history suggests has a tendency to be a wild beast when it escapes its normal ring-fencing. Higher inflationary pressures will not immediately become negative for equities because excess capacity coupled with inventories buildup provide a cushion for near term .
A mild positive inflation shock has historically been associated with positive real returns in equities.
It’s actually a large deflationary shock that has been associated with negative real returns.
Peter analysis concludes that
“Equities have historically delivered negative real return when inflation has sustained its growth rate above 4%. This is the real danger for equities.”