Normally, a $2 trillion spending announcement by the U.S. government would send borrowing costs skyward as investors would want more protection against rising long term rates. Last week the U.S. Administration signed such a spending bill to counter the negative impact of COVID-19. Yet, Treasury yields did not increase as the bond market took the additional borrowing in its stride.  Market participants now expect the Fed to conduct a strategy of yield control--- copying a standing policy used by the Bank of Japan starting in 2016. The Fed and other central banks around the world do not want to see bond rates rising, since a steeply positively sloped yield curve would undermine their stimulus packages and push up government borrowing costs. 

Yield control harkens back to WWII days when the U.S. Treasury needed to fund the war effect. An agreement was reached between the Fed and the Treasury that capped the Treasury’s borrowing costs by purchasing government debt at certain level---at that time it was set at 2.5% for 10-year bonds. After the 2008 crisis, the Fed undertook a variation of yield control with rounds of quantitative easing (QE) in which it purchased both government bonds and mortgage-backed securities to provide additional liquidity aimed at encouraging business to accelerate capital expansion. The Fed did not have a target yield rate explicitly in mind, rather it let the market determine rates beyond the short term.

Yield curve control differs from QE. QE involves the Fed purchasing quantities of bonds as a borrower of last resort. Whereas, yield curve control is aimed at the prices of bonds. In 2016 the Bank of Japan committed to peg the 10-yr Japanese Government Bond at zero percent. Consequently, the BoJ stands ready to purchase outstanding bonds in sufficient quantities to prevent the 10-yr from falling below the target yield. The BoJ enters the market on any given day to ensure the market doesn’t stray far from the target.

What lies behind a decision to undertake yield control? The major issue concerns whether the bond market can absorb every increasing amounts of public debt in support of an unprecedented spending spree at all levels of government. To the extent that the Treasury market is the benchmark for state and local government debt, as well as private corporate borrowings, it is crucial that Treasuries yields remain low. At this point, the yield control is not official Fed policy but we can expect that it will enter the public debate soon. Critics point to the Japanese experience in yield control in which the yield curve is essentially flat, yet the policy has not resulted in economic expansion. More importantly, the BoJ now dominates the whole government debt market. Also, there is the concern that as the Fed soaks up more and more government debt, lawmakers’ spending will go unchecked. Right now, the economic crisis created by COVID-19 pushes that concern way off to the sidelines.