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Yield Curve Control In Forex Trading
We have a quick question here from Kevin who asks, “What exactly is yield curve control?”
Now recently there’s been lots of comments in financial news regarding the possibility of some central banks like the Federal Reserve adopting a yield curve control policy. And even though it will be new for the Fed if they go for it, we do already have some other central banks like the Bank of Japan and RBA who currently are using this policy.
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So to start off understanding yield curve control, we need to understand what the yield curve is. So, the yield curve is basically a representation of the type of yield for various bonds or securities of different maturities.
So, when investors invest over a shorter time frame or shorter time periods, there’s arguably less uncertainty, for example, about the next three months or six months, et cetera, compared to the next 10 years from now.
What normally happens is for the investor that wants to buy longer data securities, they will obviously require more yield for that increased uncertainty over the larger time frame that they buy the securities in. So, to mitigate the risk for holding longer-term debt, investors will require a higher yield, and this means that usually your yield curve will slope upwards, with yields on shorter durations, securities being lower than that of the longer-duration securities.
Now the way that central banks would usually affect the yield curve is by setting shorter-term interest rates higher or lower. Right?
So the challenge facing central banks right now, or in any type of economic crisis like we had back in the global financial crisis as well is how to keep the backend of the curve from moving significantly higher when you already have your short-term interest rates close to zero or at 0%. So a possible answer for them to do that is yield curve control. So with yield curve control, the central bank can keep rates lower for longer, which will basically help the economy recover and can also help keep the government’s borrowing costs lower.
Now, they do this by basically choosing a specific maturity, so later they choose three-year bonds like the RBA. They can basically choose a target rate for that three-year bond yield, let’s call it zero spot two five percent, again, like the RBA. And what they will do is they’ll say, “Okay. “We want to keep the three-year yield “at zero spot two five percent. “And we want to control the yield curve synthetically “by basically buying securities in whichever quantity “in order to peg the rate at that desired level.”
So this will basically require the central bank to buy securities just like you’re in QE, but the sole purpose isn’t really in the same sense as traditional QE. You’re basically only buying those bonds to try and control the yield curve. Now, this will normally affect the economy.
Theoretically speaking, it should be supportive for the economy in terms of growth as it would keep interest rates low, which would obviously lead to more businesses being able to loan money, more consumers being able to loan money. And that should theoretically also lead to a weaker currency.
Now, if the Fed, for example, opts for a yield curve control and keeps their unlimited QE program at the same time, that would probably be seen or see a lot more U.S. dollar downside and could see some further upside in things like gold. However, as was the case with the RBA and the BOJ, once the central bank reaches its specific target for the yield curve control, let’s again use that three-year yield example at zero spot two five percent, they can basically get away with far less bond buying in the long term because they just need to maintain the rate at that specific level.
Now, if the Fed opts to replace their unlimited QE program with the yield curve control, that could see lots of dollar upside as it would possibly suggest fewer bond purchases and would possibly be seen as a tapering exercise from the Federal Reserve. So, it’s not only about the yield curve, but also how the Fed will respond to the other policy measures in line with that yield curve, which is also important to keep in mind.
But that should give you a broader understanding of what exactly they mean by yield curve control and how it theoretically should impact the economy as well as the currency.