In Part 4 of our series on interest rates and yield curve control, we will examine two charts and two related tables to help explain yield curve control and implications for the Treasurys market.
The first three parts are available here:
Part 1, https://www.cumber.com/cumberland-advisors-market-commentary-interest-rates-and-yield-curve-control-part-1/
Part 2, https://www.cumber.com/cumberland-advisors-market-commentary-interest-rates-and-yield-curve-control-part-2/
Part 3, https://www.cumber.com/cumberland-advisors-market-commentary-interest-rates-and-yield-curve-control-part-3/.
The first chart and table will depict certain yield curves as of September 30, 2019. We start here because this date falls prior to the pandemic’s impact on global monetary policies. Chart 2 and Table 2 are as of November 30, 2020, and are assembled from the same data sources and depict the same yield curves but after the US election and after the announcement of forthcoming vaccines. We’re assuming that markets have made most of the adjustments for the COVID Shock and its aftermath and the US Election cycle. We acknowledge that a January 5 political event could alter these charts. We plan on a part 5 and will attempt to capture any significant changes in it.
The visible difference between the charts is dramatic but needs a basis of comparison or a reference. That is why we also include the tables to help clarify the story. For the tables we’re building on the seminal work of Robert D. Laurent, published in a paper entitled “An interest rate-based indicator of monetary policy” (Federal Reserve Bank of Chicago, 1988). We’re showing the difference (spread) between short-term and long-term policy interest rates in order to make clear the differences in yield curve slopes, so that we may compare various currencies and their central bank-managed yield curves. Notice how the US had the flattest yield curve in Table 1 and now has the steepest, as depicted in Table 2. Also notice how the euro and yen curves are essentially unchanged. Please remember that Laurent’s work argues that the slope of the yield curve indicates the degree of monetary stimulus. If Laurent is correct, the US has become the most simulative from earlier being the least simulative while Japan and the eurozone have accomplished no additional stimulus with their added QE. Also notice that on September 30, 2019, China’s was the most stimulative yield curve slope.
We could add other currencies, as we did in the early part of this series, but doing so here wouldn’t add benefit for the reader. Including other currencies would only confirm what you can already see in these charts and tables. We plan to develop the other currencies in part 5. And we plan to show alternate ways to evaluate the slopes of these yield curves.
Here is the first chart and table series. Remember, the date selected is September 30, 2019 (using closing price data). At that time, the COVID pandemic was unknown. Monetary policy worldwide was on what folks thought to be a predictable path, and the economies of the world were on forecast tracks that shared a broad consensus. The impacts of tariffs and protectionism (including a tentative phase 1 trade deal) were assumed to be embedded in the market-based prices revealed in the September 30, 2019, chart and table. Markets were pricing in an expected continuation of the Trump administration policies into a Trump second term.
Chart 1. Yield Curve Control, September 30, 2019
|Curve Name||US Treasury||US AAA MUNI||CNY||JPY||EUR|
|Short-Term T-Bill Rate (3M)||1.93||1.254||2.426||-0.301||-0.721|
|Long-Term Bond Rate (30YR)||2.114||2.11||3.77||0.331||-0.06|
Please note that we have inserted the yield curve from World War 2 into these charts as a reference. It is not in the tables. We include that WW2 yield curve in this series because WW2 was the only time the Federal Reserve used its absolute monetary power to control the slope of the entire yield curve. The Fed did so by maintaining a “cap” on the interest rates at all maturities. The Fed might have permitted those rates to go lower than the cap. We do not know if they would have done so; that is a counterfactual. Interest rates during the WW2 era never exhibited downward pressures, so the cap was maintained for four years, and the rates never changed.
In Chart 1 note the WW2 yield curve (purple). Also notice the zero yield line (black). Those two lines are references for you. Let’s discuss each.
In World War 2 the Federal Reserve instituted total yield curve control shortly after the Pearl Harbor attack. From 1942 through 1946, interest rates in the United States were essentially unchanged. For further background see our April 7 commentary, “WW2 versus WWC: The Doolittle Moment” (https://www.cumber.com/cumberland-advisors-market-commentary-ww2-versus-wwc-the-doolittle-moment/.) Our references for this data include the famous Friedman-Schwartz treatise, A Monetary History of the United States: 1867–1960 (https://www.amazon.com/Monetary-History-United-States-1867-1960/dp/0691003548), and the extraordinary History of Interest Rates, by Sidney Homer (https://www.amazon.com/History-Interest-Rates-Fourth-Finance/dp/0471732834/). My personal view is that both of those treatises are required reading for anyone engaged in professional bond management and advising about the securities markets.
During the World War 2 era, the Fed maintained an unlimited bid at the very short end of the yield curve. The 90-day Treasury bill yield was 3/8ths of 1% and never changed. The rest of the yield curve was “managed” by the Fed to maintain control. Throughout that period, the Fed never had to face the prospect of rates falling below the cap. Global forces worked to avoid the “problem” of rates going lower than that. Remember that the world was on a gold standard in those days and that international flows were disrupted by war.
Now we have a different set of circumstances. All currencies are unanchored to gold. They float against each other. This is true whether the float is unrestricted or “dirty” due to intervention by a government or its central bank.
Here are Chart 2 and Table 2. Compare with the corresponding chart above and the dramatic shift is easily seen. Remember the World War 2 curve is the only constant and there for your reference.
Chart 2. Yield Curve Control, November 30, 2020
Table 2. Yields, November 30, 2020
Think about the yield curves that you see. There is the US dollar block, anchored by the US Treasury curve. And there is the euro block, which has its shorter-term anchor in negative rates, and the yen block, which also uses a negative-rate anchor. And there is China, the world’s second-largest economy, which is in the early stages of opening up its finances and expanding a foreign footprint in monetary issues. Remember, China is just getting started. It has the world’s second-largest domestic bond market, the onshore market. It is just beginning the process of developing an offshore or international bond market. We have also included the American AAA municipal bond curve, since it represents the highest-grade bond issuance in a $4 trillion market.
Those regions and countries (and their currencies) that are practicing full yield curve control include Japan (yen), Europe (euro), China (yuan), and others that we have mentioned earlier in this series but are not showing on the charts in Part 4. Note that in the modern day it is not necessary to cap all maturities on the yield curve to achieve control. Today’s unanchored fiat-currency financial world is quite different from the one that existed during and after World War 2.
In order to achieve yield curve control, it is not necessary for a central bank to anchor every maturity. The bank actually needs to anchor only two points on the yield curve. Then market agents will use forward-rate trading adjustments to stabilize the rest of the curve. The eurozone has now anchored two points on the yield curve with its policies of tiering and TLTRO. Japan has similarly anchored two maturities at two different rates. China is evolving in the same direction by internal control of interest rates in the onshore bond market. And the political shift in Hong Kong will now propel China into a more global role, as Hong Kong is its conduit to global financial channels. Beijing has adopted yield curve control for the yuan. For example, China recently issued a 3-year-maturity bond with a rate above 3%. China has successfully sold a euro-denominated bond at negative interest rates. (See “China Borrows at Negative Rates for the First Time,” https://www.wsj.com/articles/china-borrows-at-negative-rates-for-the-first-time-11605769378?mod=hp_lead_pos4.)
We believe that China will establish increasing credibility in global finance by implementing yield curve control. And it will demonstrate no default risk by never missing a payment. The yuan will have to adjust against other currencies in two ways. One adjustment mechanism will be the decisions of the Chinese government in its currency exchange-rate policy. The other will be the adjustment made by global market agents as they evolve expectations of China’s behavior. Chinese policy makers are very well trained in monetary policy and fully understand what they have to do to gain credibility and to establish China in the global financial system.
That leaves only the United States practicing no formal yield-curve-control policy. However, we expect the Federal Reserve to use the weighted average maturity (WAM) method of establishing yield curve control. See our recent commentary on the Fed’s path (https://www.cumber.com/cumberland-advisors-market-commentary-feds-path-also-why-barbell-not-ladder/). The comparison of slopes or spreads demonstrates that the US dollar already has a term structure that is somewhat parallel to those of Japan and the eurozone. This happens because the global use of USD derivatives pressures those yield curves into a parallel structure.
US monetary policy anchors only from the short-term policy interest rate. The rest of US rates are adjusted by buyers and sellers in the global marketplace of US Treasury debt, and all other US debt tiers are derived from the Treasury curve. We have inserted the AAA municipal curve in our charts to demonstrate that alignment. Please note that this is the American curve of tax-free sovereign-state debt and is limited to those states with a AAA credit rating. Also note that global investors ignore the tax policy of the United States because it doesn’t apply to them. Thus US Treasury interest is fully taxable to Americans while municipal bond interest is not taxed. Meanwhile, the interest rates are nearly the same. The tax on US Treasurys makes selected municipal bonds a bargain for an American taxpayer who is willing to exploit that opportunity.
As we have described in parts 1, 2, and 3 of this series, the influences on yield curves are global and employ currency hedges with the short-term rate and derivatives at longer maturities. Thus we can use our previous work to estimate that the US Treasury yield curve will eventually stabilize at or near an alignment with the other yield curves of the world. In time they will all approach a parallel term structure. If they don’t, market agents will seize the arbitrage available to drive those rates into close alignment.
By this method we can project that the interest rates in the US Treasury curve are nearing that stable alignment. With a 10-year Treasury yield of about 1% (100 basis points), we can see that the alignment is close to completion. The same is true for other maturities. Could the 10-year note yield a full 1.5%? Yes, of course. Could it rise to 2%? Maybe, but it would take a lot of adjustment in the global derivative structures and significant economic outlook changes to get it there.
In other words, the Fed doesn’t have to worry too much about an interest rate cap, as it did in the World War 2 era. And the Fed will see market agents create changes in the yield curve slope as the US yield curve aligns with those across the rest of the world, where full yield curve control is already in place.
The differentials among the yield curves of the world will be driven, in part, by the currency futures market’s collective opinion about the foreign exchange ratios to come. We expect that situation to become the new normal in global interest rates as long as the major central banks of the world remain in their highly expansive mode, with stimulus-oriented policies. The most important player now is China. It has the skills and size and determination to achieve global stature in monetary affairs. And Chinese interest rates are now the highest among the major players in the world. As the Chinese offshore bond market opens up, the impact of China will become more and more visible.
Many politicians would bash China, and we see the blame-game politics of China bashing playing out every day. But the Chinese leadership is very patient, in our opinion. It will make every decision in a methodical manner and in China’s best interest. It is not likely to engage in bullying or shrill politics. It doesn’t have to.
Therefore, we conclude that China’s default risk is near zero. The Chinese currency, the yuan, will gradually become more and more desired as an additional reserve holding. Those trading partners who are expanding their terms of trade with China will be the ones who enlarge their yuan reserves.
So, if yuan reserve usage expands in the post-Hong Kong-takeover era, which currencies are likely to be most at risk? That is the most difficult of questions. The obvious answers are the largest currency (the US dollar) and the second largest (the euro), but other currencies are also vulnerable, and exchange-rate changes are notoriously hard to forecast in both magnitude and timing. Here’s a short news clip about China and Indonesia: https://www.youtube.com/watch?v=rXuy_4iOBZ4. Those two countries are moving from settling most of their trade in US dollars to settling the trade in the Chinese and Indonesian currencies. Hat tip to Paul Schulte for the YouTube link. Let’s just examine this one item for a second. Both countries end up needing more of the other country’s currency as a reserve. Neither country needs as many US dollar reserves as it did before this change in settlement payments. Please remember that this is just one example. Also remember that the original reason for maintaining reserves of other countries’ currencies is to facilitate settlements of terms of trade.
In summary, we’ve delivered a four-part series to show the sequence of elements that leads to yield curve control and the influence of the derivative mechanism now at work in the world as pandemic-driven global central bank activity unfolds. It is impossible to know how long these trends will last, as the pandemic’s effects are going to be determined by science and medicine and human behavior and the resulting rate of disease spread and deaths. But we do expect that the massive global monetary expansion will be with us for many years. Right now, every major central bank in the world is on the “easy” side when you measure easy by the size of the balance sheet of the central bank. We do not expect that policy stance to change for at least several years, if not longer.
We at Cumberland hope this series has been helpful to readers. It helps explain to our actively managed bond portfolio clients why we are engaged in barbell strategies now and why we think that the 40-year bull market in US Treasury notes and bonds is coming to an end. We’re working on part 5.
We will close with a list of suggested additional readings that may add to the discussion.
“Japan’s Experience with Yield Curve Control,” Federal Reserve Bank of New York: Liberty Street Economics, June 22, 2020, https://libertystreeteconomics.newyorkfed.org/2020/06/japans-experience-with-yield-curve-control.html
“The Fed has better tools than yield curve control,” Peterson Institute for International Economics, July 13, 2020, https://www.piie.com/blogs/realtime-economic-issues-watch/fed-has-better-tools-yield-curve-control
“Commercial Banks under Persistent Negative Rates,” Federal Reserve Bank of San Francisco, September 28, 2020, https://www.frbsf.org/economic-research/publications/economic-letter/2020/september/commercial-banks-under-persistent-negative-rates/
“Gold reserves in central banks – 2020 survey results,” Central Banking, November 10, 2020, https://www.centralbanking.com/central-banks/reserves/gold/7706776/gold-reserves-in-central-banks-2020-survey-results
“Lessons from the Riksbank’s negative rates experiment,” Central Banking, November 30, 2020, https://www.centralbanking.com/central-banks/monetary-policy/unconventional-monetary-policy/7713616/lessons-from-the-riksbanks-negative-rates-experiment
We also recommend this book by Norbert Gaillard, who does superb credit risk analysis on a global scale: Country Risk: The Bane of Foreign Investors, https://www.amazon.com/Country-Risk-Bane-Foreign-Investors-ebook/dp/B08CMV5FYC/
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