Navigating the Shift: FED Pivots into Yield Curve Control Financing – Nov 7th 23

Last week ushered in a series of important developments in the economic landscape, necessitating a proactive approach to this forth coming week’s outlook for our esteemed audience…

The winds of change have undeniably swept across the financial horizon. In accordance with our earlier projections, the Federal Reserve (FED) adopted a notably dovish stance following a comprehensive review of policy decisions by central banks both near and far. The decision to maintain interest rates within the 5.25-5.5 range was largely anticipated, but the underlying shift within the FED’s overarching strategy emerged as the pivotal development.

The revelation surfaced during Tuesday’s refunding announcement, serving as the metaphorical “red pill” for the market. This marked a pivotal alteration in the FED’s approach to financing the United States Treasury and hinted at the impending introduction of a modified iteration of Yield Curve Control (YCC) or Yield Curve Control Financing (YCCF) as it stands. To place this into historical context, the last instance of YCC was witnessed between 1941 and 1952 during the crucible of World War II, designed to cap borrowing costs for the U.S. Treasury during this fiscally demanding period. It is imperative to recognize the resonance of the current geopolitical landscape with the historical backdrop. Furthermore, the FED has acutely acknowledged the vulnerability of the prevailing economic conditions, not merely on account of the data emanating from consumer behavior, but more so in response to the dour forecasts articulated by key stakeholders in the issuance of credit and the deteriorating financial health of their portfolios, particularly as it pertains to longer-dated U.S. government bonds.

In light of these multifaceted concerns and the pronounced volatility in interest rates, which the FED itself engendered through its recent tightening cycle, coupled with lackluster demand from both domestic and international buyers for U.S. dollar-denominated debt with tenors exceeding seven years, the FED has opted to implement a controlled approach to the issuance of new debt across the key segments of the yield curve. This step, akin to a rudimentary form of YCC, signifies a significant shift or pivot in the FEDs mandate. The refunding announcement delineates the allocation of $48 billion to the 3-year point on the yield curve, while reducing the supply of 10-year notes to $40 billion and curtailing the 30-year bond issuance to a more manageable $24 billion.

While some may perceive this as an exercise in financial minutiae, it is worth emphasizing that managing the issuance of debt is the inaugural step towards stabilizing the volatility that has gripped the rates market. While not a strict incarnation of YCC, where central banks purchase their own newly issued securities to calibrate specific interest rate levels on the curve, this endeavor is instrumental in shaping the curve’s trajectory by regulating the demand emanating from market participants. As previously highlighted in our communications regarding term premia and the normalization of the yield curve, the precise level may fluctuate, but the endeavor to maintain a flat to moderately steep slope is indicative of a move towards normalcy. This, in turn, empowers investors to reconsider their asset allocations in both fixed income and higher-risk asset classes.

Notably, while the media continues to focus on declining payroll figures, which lend support to the FED’s decision to maintain or potentially lower interest rates moving forward (a matter that is hardly groundbreaking news), they have overlooked the FED’s maneuver in recognizing the significance of structural adjustments within the U.S. rates market.

So, how did the markets react to these developments? With the advent of a new month, coupled with the comprehensive refunding plan, the absence of policy rate adjustments, and lackluster economic indicators, the markets witnessed a substantial relief rally, or short positioning rebalance. It is imperative to distinguish this rally from a short squeeze, as trading volumes remained relatively moderate throughout the week. As we forewarned earlier in the year, any signs of the FED halting or shifting its stance prompted a resolute upward movement in rates. Consequently, 2-year rates surged by 20 basis points, 5-year rates by nearly 35 basis points, 10-year rates by 40 basis points, and 30-year rates by 25 basis points. Mortgage rates, mirroring this trend, also experienced a momentary reprieve.

However, it is prudent to tread with caution from this juncture. While we may anticipate further support for risk assets and capital reallocation as Treasury bills continue to reach maturity, moving too swiftly along the yield curve may rekindle inflationary pressures and disrupt markets once more. This represents a delicate balancing act that the FED must undertake, who still choses to operate on lagged economic data, during a complex geopolitical landscape, and a likely contentious political environment as we approach next year’s presidential campaign.

In this context, rate-sensitive sectors of the economy are poised to exhibit a renewed correlation with the yield curve, provided that the structural adjustments remain as described earlier. Portfolios marked by robust balance sheets in corporate entities should reap benefits, however, be weary of those facing refinancing obligations within the next 2-3 years as at no point have lower rates in the front end been suggested (cuts will only be put in play should the US consumer or Goliath itself fails). Short term correlations will continue normalizing as market volatility abates. We anticipate signs of rotation and redistribution within the relatively affluent sectors of the market, a conjecture that has loomed over this year and materialized only lightly last week. The broader indexes include too many toxic assets to make owning them in the current environment attractive. Although, tactical plays here will be plentiful as liquidity remains a concern.

Lastly, a point of concern pertains to the U.S. consumer, the “David” in our Goliath analogy, and it introduces an intriguing facet to our prior analysis. A third alternative appears to be emerging, where U.S. taxpayers may opt to bolster the U.S. Treasury by investing in short to medium term, low-risk government paper. With yields hovering around 5% in tenors spanning 1-5 years, the allocation of savings by taxpayers towards fixed income instruments has, for the first time in long time, become a genuine choice and a prudent measure in de-risking investment portfolios. The FED should continue to cater to David’s duration needs and current demographic. Failure to elect this opportunity may ultimately prompt the FED to embark on full-fledged YCC in the foreseeable future as they continue financing the increasing deficits in the US.