The Pre-mortem: Yield Curve Control

Don't worry it will all be over soon.

The Yield Curve Control program that the RBA deployed in March 2020 is set to shuffle off this mortal coil at tomorrow’s Board meeting - two years before it’s planned expiration date! What happened?

What is Yield Curve Control?

On 19 March 2020, the Board announced a target for the yield on the 3-year Australian Government bond of around 0.25 per cent. Later that year in November the RBA reduced this target to around 0.1 per cent. This was an effective extension of its conventional approach of targeting the overnight cash rate.

Responding to an improving economy, the RBA decided at their July 2021 meeting to sunset the program with the target applying to the April 2024 bond – rather than continuing to roll it to a later-maturity bond.

How well did the program work? Up until last week pretty darn well as the figure below shows.

Initially the scheme was not completely credible, it took 11 days and $27 billion dollars worth of purchases before the initial yield curve control target was first achieved. However given the economic turmoil occurring in March 2020 that is a pretty good result.

Indeed the purchases quickly tapered off and after 6 weeks the target was closely achieved without further bond auctions being required. For a program that was designed to lower long term interest rates while having a relatively low impact on the bond market it was immensely successful.

Over the subsequent 18 months the RBA only intervened occasionally, typically when the yield drifted ~2 basis points above the target. However these interventions were small and short lived. Notably the target was not symmetric and would frequently fall well below the official headline yield.

Ending in tears

However the policy quickly fell apart in October when yields on the April 2024 bond jumped to 5 basis points above the target. An initial bond purchase of $1 billion tempered yields for 3 days, but when no further purchases were forthcoming the yield quickly jumped to 68 basis points above target!

It is now clear that barring some Lazarus-esque twist ending the yield curve target will be formally abandoned, or at least substantially wound back, at tomorrow’s board meeting.

What happened? 

Clearly market believed that the April 2024 date was no longer a time-consistent promise and that a future board would want to raise interest rates well before that date. But it’s not obvious that such a breakout was inevitable. Previous upticks in the yield were successfully suppressed. 

However last week when the market started to push down the price the RBA was slow to intervene, only tipped their toe in the water when they did, and failed to follow it up with subsequent purchases as was their previous modus operandi. It seems likely that this timid approach to market interventions sent a signal that they weren’t truly committed to the target and that the price was going to fall sooner or later. Indeed yields started rising again even well before the above expectations CPI print that occurred on the 27th of October.

The fundamental problem was that YCC without an explicit commitment to keep the cash rate low was going to be vulnerable to runs. The RBA never formally committed to keeping the cash rate constant, only promising that it was their ‘central scenario’ for their forecast. 

This meant that if markets thought that the economy would significantly outperform this central scenario, thus leading interest rates to rise earlier than planned, the RBA would be forced to intervene heavily into the bond market or abandon the peg. 

When faced with this dilemma they (will) chose the latter as the least worst option.

The Upshot

Where does this leave the policy of Yield Curve Control? Certainly the practical experience with the policy leaves much to be desired, and the bitter ending means it is unlikely to be deployed again any time soon. 

While understandable I think this is a shame. In retrospect, the high levels of uncertainty involved in the Covid-19 economic crisis made long term policy commitments relatively high-risk. The successful invention of high quality and vaccinations and their (eventual) widespread rollout created a series of positive shocks that was at best going to create serious doubt about the RBA’s pessimistic path for the cash rate.

However just because the 2020 recession was unusually volatile is no guarantee that the next one will be.

Notably this sour ending would have been avoided entirely if the RBA had decided to remove the target a mere four weeks earlier when the yield was well below the 0.10% target! Indeed the program might well have been considered a great success.

I think there are few key lessons from this episode.

• The RBA should be more explicit about how it’s policies will be implemented - especially when they are introducing novel programs. More systematic rules and less discretion would provide clearer guidance and better outcomes.

• Any future decision to peg a financial market should carefully consider what future commitment this will involve and what it’s potential exit strategies will be - including the potential cost of having to abandon the peg!

• Finally, the RBA should carefully consider whether it has the ability or desire to make binding commitments on future policy decisions. In theory the ability to make these promises is a powerful monetary tool. But the messy end of YCC may have cast some doubt on their ability to commit which should be directly addressed by the Bank.

• The RBA will probably never try Yield Curve Control again.