By Brian Chappatta
Benchmark 10- and 30-year U.S. Treasury yields soared to 12-month highs on Tuesday in a selloff steep enough to make seemingly invincible stock indexes shudder. Like clockwork, market chatter started up: What will the Federal Reserve do to stop this move? Will it institute yield-curve control?
Take a deep breath. Now, to bring up yield-curve control misunderstands how Fed officials, notably Vice Chair Richard Clarida and Governor Lael Brainard, have said they envision carrying out the policy, which remains deep within the central bank’s toolkit. Simply put, yield-curve control has never been about squashing longer-term yields, like those on 10-year notes or 30-year bonds. Instead, it’s a way to make sure bond traders don’t try to strong-arm the Fed into raising short-term interest rates before it’s ready to do so.
Consider these remarks from Brainard in November 2019, which detailed how she’d consider conducting monetary policy at the effective lower bound of interest rates. “There may be advantages to an approach that caps interest rates on Treasury securities at the short-to-medium range of the maturity spectrum — yield-curve caps — in tandem with forward guidance that conditions liftoff from the ELB on employment and inflation outcomes,” she said. Brainard uses the phrase “short-to-medium” twice more in that speech. Given that the Fed’s “dot plot” projections extend about three years, followed by a “longer-term” dot, it stands to reason that the caps likely wouldn’t go beyond three to five years.
As for that last part on forward guidance, remember the Fed has already committed to such a policy. In September, the central bank pledged to keep the fed funds rate unchanged in a range of 0% to 0.25% “until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.” Yield-curve control would come into play only if bond traders anticipated the economy would meet those thresholds far more quickly than the Fed did.
So far, that hasn’t happened, even with the swift moves at the long end. Two-year Treasuries still yield just 0.12%. Three-year Treasuries are at 0.23%. Even five-year Treasuries, which reached the highest since March 20 on Tuesday, are a mere 0.57%. Before 2020, the record-low for five-year yields was 0.5345% in July 2012. Suffice it to say, the bond market is not pricing in much in the way of Fed rate increases in the coming years by any measure.
What bond traders are pricing in, rather, is the combination of accommodative monetary policy and supportive fiscal policy successfully boosting economic growth and inflation. This is by design. A steepening yield curve, in fact, should be music to Chair Jerome Powell’s ears, not cause for alarm. The curve from 5 to 30 years is 152 basis points, the steepest since October 2015, while the gap between 2-year and 10-year yields is 119 basis points, the most since March 2017. Real inflation-adjusted yields are on the rise across the curve as well.
Still unconvinced the Fed won’t move to bend the longest-dated Treasuries to its will? After all, in Brainard’s speech, she did argue that “yield-curve ceilings would transmit additional accommodation through the longer rates that are relevant for households and businesses.” How does that square with benchmark U.S. yields marching higher?
Well, consider one long rate relevant to households: The Freddie Mac 30-year mortgage rate. It’s currently 2.73%, not far from the record low 2.65% set on Jan. 7. The 10-year Treasury yield, meanwhile, has jumped about 40 basis points since the beginning of the year to 1.31%. The difference between the two rates is certainly lower than it was in 2020, but it’s roughly in line with the average spread over the past decade. It’s certainly conceivable that mortgage rates could remain near all-time lows even as benchmark Treasury yields grind higher.
Meanwhile, the average investment-grade company pays just 92 basis points over Treasuries to borrow, approaching the record low 76 basis points from 2005. If longer-term yields keep rising, that means investors see a brighter economic outlook, which should bolster the creditworthiness of corporate America and serve to compress credit spreads further, potentially offsetting the rise in underlying yields.
To be clear, the Fed is certainly showing no eagerness to institute yield-curve control. Minutes of the Federal Open Market Committee’s June meeting revealed the staff discussed “in light of the foreign and historical experience with approaches that cap or target interest rates along the yield curve, whether such approaches could be used to support forward guidance and complement asset purchase programs.” During the conversation, “nearly all participants indicated that they had many questions regarding the costs and benefits of such an approach.” The fact that explicit references to curve control have disappeared in more recent Fed minutes suggests policy makers found the costs too steep for now.
Perhaps the Fed will revisit yield-curve control someday. But it won’t be because of rising long-end Treasury rates. As long as the yield curve is steepening for the right reasons — expectations for stronger growth and higher inflation, combined with years of easy monetary policy — Powell and his colleagues will be just fine watching from the sidelines.