Live After Quit

Yield Curve Control: Bubbles and Stagnation

Central banks do not manage risk, they disguise it. You know you live in a bubble when a small bounce in sovereign bond yields generates an immediate panic reaction from central banks trying to prevent those yields from rising further. It is particularly more evident when the alleged soar in yields comes after years of artificially depressing them with negative rates and asset purchases.

It is scary to read that the European Central Bank will implement more asset purchases to control a small move in yields that still left sovereign issuers bonds with negative nominal and real interest rates. It is even scarier to see that market participants hail the decision of disguising risk with even more liquidity. No one seemed to complain about the fact that sovereign issuers with alarming solvency problems were issuing bonds with negative yields. No one seemed to be concerned about the fact that the European Central Bank bought more than 100 percent of net issuances from eurozone states. What shows what a bubble we live in is that market participants find logical to see a central bank taking aggressive action to prevent bond yields from rising … to 0.3 percent in Spain or 0.6 percent in Italy.

This is the evidence of a massive bubble.

If the European Central Bank was not there to repurchase all eurozone sovereign issuances, what yield would investors demand for Spain, Italy or Portugal? Three, four, five times the current level on the ten-year? Probably. That is why developed central banks are trapped in their own policy. They cannot hint at normalizing even when the economy is recovering strongly, and inflation is rising.

Market participants may be happy thinking these actions will drive equities and risky assets higher, but they also make economic cycles weaker, shorter, and more abrupt.

Central banks have exhausted tools like repurchasing bonds and cutting rates, the diminishing returns are evident. Now they look to Japan, of all places, to look at yield curve–control policies.

Many articles hail the Bank of Japan’s curve control strategy as a big success. It has managed to keep bond yields inside a narrow range around 0 percent, since it adopted its yield curve control (YCC) policy in 2016.

However, all this has done is disguise risk and lead the economy to massively indebted stagnation.

Why? The central bank applies constant changes in its purchases of sovereign bonds with different maturities to prevent the yield curve from steepening and bond yields from rising above a certain level, which could cause an economic crisis as risk-off takes over.

There is a deeply flawed view of markets in this theory. YCC does not reduce the risk of a crisis, simply disguises it by manipulating the price of sovereign bonds, the alleged lowest risk asset. As such, market participants always take significantly more risk than what they want or should, because the price of risk and the shape of the curve is artificially managed by the central bank.

The idea behind YCC is that savers will stop purchasing or selling sovereign bonds when they perceive that the economic cycle is changing, and that investors’ funds will be directed to finance the productive economy and put to work to invest in industry and provide credit to households. However, that does not happen. Market participants know that the shape of the yield curve is manipulated, and that risk is hidden, so most of the funds go to liquid, short-term assets and to refinance zombie firms that are already in high debt. Overcapacity is perpetuated, risky asset inflation soars, those that are already indebted are refinanced eternally and low interest rates push high liquidity to the least productive parts of the economy. It is no coincidence that the number of zombie firms has soared in the period when YCC was implemented. It is even less of a coincidence that unproductive debt has ballooned.

Allowing rates to adjust to reality through free float would be more effective to transfer liquidity to the productive segments of the economy and strengthen the recovery. It would also reduce the incentive to overspend from governments. Central banks say they do not cut rates but just follow market demands. If that is the case, let them float freely. But they will not.

YCC will likely be openly implemented by the ECB and the Federal Reserve, but it is in place de facto already. It will not solve anything. Just make bubbles larger and the economy weaker. Just like in Japan, it will not prevent a crisis nor make the economy better prepared to face it, it will not lead to stronger economic recoveries either. The only thing that YCC does is to perpetuate bloated government spending and zombify the economy at the expense of real wages and the productive sectors. Once YCC fails, like all other financial repression tools, central banks and governments will say that it did not work because they did not do enough. It is never enough when they use other people’s money.