Debt Monetization and Yield Curve Control
What are they and will we experience them? - Article #53
In this 12-minute article, The X Project will answer these questions:
I. Why this article now?
II. What does the QRA tell us?
III. What is debt monetization?
IV. What is yield curve control?
V. What is Japan’s experience?
VI. Can we expect debt monetization in the U.S. again?
VII. What about YCC returning?
VIII. Is it already here?
IX. What does The X Project Guy have to say?
X. Why should you care?
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I. Why this article now?
When The X Project was first launched, this article was going to be one of the first I would write that wasn’t a summary of an influential book. I have written fifty-two prior articles and covered twenty-one books, and so I found thirty-one reasons to write other articles before now.
Ok, so it appears I can do basic math… that’s nice. But why this article now? On Monday, April 29, and Wednesday, May 1, the U.S. Treasury Department will release its Quarterly Refunding Documents, a.k.a. QRA or Quarterly Refunding Announcement, and here is what the website looks like:
The QRA has become a highly anticipated and often market-moving event in recent quarters.
II. What does the QRA tell us?
On Monday, April 29, 2024, we will get the “Financing Estimates: 2024 - 2nd Quarter,” and it will give us three important data points:
What the Treasury expects to borrow in the April - June 2024 quarter, and how it compares to the first estimate from a quarter ago.
What the Treasury expects to borrow in the July - September 2024 quarter, which is the first estimate for this quarter
What the Treasury actually borrowed in the January - March 2024 quarter, and how it compares to the second estimate from a quarter ago.
If the amounts come in higher than previously estimated and/or higher than expected, this tells us there will be a larger supply of T-bills and T-bonds sold to the market, which might push prices down and yields up.
But the more likely market-moving news is Wednesday morning when we will receive the “Policy Statement: 2024 - 2nd Quarter” and the “TBAC Report to Secretary: 2024 - 2nd Quarter.” TBAC is the Treasury Borrowing Advisory Committee. In those reports, we will learn the composition of those borrowing plans - how much will be borrowed in shorter-duration securities and how much will be borrowed in longer-duration securities.
In recent years, we have learned that the liquidity of the U.S. Treasury market has limits and that too much supply of longer-duration bonds can cause the market not to function properly or as anticipated.
Note, if you have not read these two articles, you should probably pause here and read them first as they explain the Treasury market dysfunction we’ve experienced recently as well as provide other important background and context for this article:
Ok, but isn’t this article supposed to be about Debt Monetization and Yield Curve Control? Yes, it is, and the QRA is related, and I’ll come back to that later, but let’s get to the title of this article.
III. What is debt monetization?
We are specifically concerned with sovereign or federal government debt monetization or monetary financing. This is the practice of a government borrowing money from its central bank to finance public spending. This process is often informally called “printing money,” it occurs when the central bank buys interest-bearing government debt with non-interest-bearing money. This is essentially a permanent exchange of debt for cash, and this increase in the monetary base is used to fund the government.
The United States has done this before in the 1940s during World War II. The U.S. government financed its war efforts by issuing debt, a portion of which was purchased by the Federal Reserve, effectively increasing the money supply. Debt monetization exceeded 1 percent of GDP for three years during World War II (1943-1945). After the war, debt as a percentage of GDP rapidly declined post-World War II. This was due to a combination of economic growth and fiscal policies aimed at reducing the debt burden. So, while the U.S. did monetize its debt during the 1940s, it was a carefully managed process and was part of a broader strategy to finance the war effort and manage the economy that also included yield curve control.
IV. What is yield curve control?
Yield Curve Control (YCC) is a monetary policy tool central banks use to manage interest rates across different maturities of government bonds. YCC involves targeting specific yields or interest rates on government bonds with different maturities, typically aiming to keep long-term interest rates at a desired level.
This approach dramatically differs from the typical way of managing economic growth and inflation by setting a key short-term interest rate. YCC primarily aims to provide more certainty and stability to long-term interest rates, stimulating borrowing and investment and supporting economic growth.
Beginning in 1942, the United States used YCC. The U.S. Treasury and the Federal Reserve agreed to keep the interest rate on long-term government bonds below a ceiling of 2.5 percent and short-term government bonds at a below-market rate of 3/8 percent. To maintain those caps, the Fed purchased as many Treasuries as necessary to hit and maintain those yields.
V. What is Japan’s experience?
Japan's recent experience with debt monetization since the early 2000s highlights its approach to handling its substantial government debt (263% debt-to-GDP ratio), the highest among developed nations. Debt monetization in Japan has been implemented through the Bank of Japan's (BOJ) extensive purchase of government bonds. This process has been critical in funding the government's deficit without raising taxes or cutting expenditures drastically. By buying these bonds, the BOJ injects money into the economy to achieve a target inflation rate that could help manage the debt-to-GDP ratio. However, this approach has not been effective as Japan, up until very recently, has been struggling with deflation for decades.
Yield curve control, introduced by the BOJ in September 2016, is a central part of its monetary policy framework aimed at overcoming deflationary pressures. Under YCC, the BOJ committed to keeping 10-year government bond yields at around zero percent and recently raised to 0.1%, which it does by buying or selling bonds as necessary. This policy is designed to help control long-term interest rates, stimulate bank lending, and encourage investment and spending. By maintaining low yield rates, the BOJ supports government efforts to stimulate the economy without exacerbating the debt situation. The YCC also indirectly supports the government by lowering the cost of borrowing, thereby making fiscal expansion more sustainable.
However, GDP growth in Japan has been anemic for the past 30 years, having grown only 25% compared to the U.S. GDP, growing by 108% over the same period. Despite that, many people look at Japan and say they have shown that debt as high as theirs can be managed effectively. Maybe, but I don’t think so. Japan’s situation is materially different on many levels. First, they had the fortune of blowing and then bursting their debt bubble first, which provided the benefit of timing for the major global deflationary forces of China’s ascendency and the integration of the former Soviet Union to be a counter-force to otherwise inflationary policies. Second, almost all of their debt was held within their own country. Third, Japan has a positive multi-trillion-dollar net international investment position. Fourth, Japan does not issue the global reserve currency. The situation is the opposite for the United States.
VI. Can we expect debt monetization in the U.S. again?
Yes, I think the Fed directly buying bonds from the Treasury will eventually happen, given how terrible our fiscal situation and outlook are. But a different form of debt monetization will likely happen first and soon.
ISDA, the International Swaps and Derivatives Association, “has over 1000 member institutions from 77 countries. These members comprise a broad range of derivatives market participants, including corporations, investment managers, government and supranational entities, insurance companies, energy and commodities firms, and international and regional banks. In addition to market participants, members also include key components of the derivatives market infrastructure, such as exchanges, intermediaries, clearing houses and repositories, as well as law firms, accounting firms and other service providers. Membership types are Primary (dealer firms), Associate (service providers) and Subscriber (end-users). ISDA Primary Membership is designed for international and regional banks, insurance companies, diversified financial firms, and energy and commodities firms. It currently includes over 200 large global institutions that deal in derivatives.”
“On March 5, 2024, ISDA submitted a letter to the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency to urge them to implement targeted reforms to the supplementary leverage ratio (SLR), the enhanced SLR framework and the risk-based surcharge for global systemically important bank holding companies that are important to preserve the resilience of the US Treasury markets, the US economy and the financial system more broadly.
To facilitate participation by banks in US Treasury markets – including clearing US Treasury security transactions for clients – the agencies should revise the SLR to permanently exclude on-balance-sheet US Treasuries from total leverage exposure, consistent with the scope of the temporary exclusion for US Treasuries that the agencies implemented in 2020.”
What does this all mean? Banks could theoretically buy an infinite number of U.S. Treasurys using capital they created out of thin air.
If you want to get into the details behind all this, James Lavish wrote a three-part article:
VII. What about YCC returning?
Yes, I think YCC, in the traditional sense, will eventually return again because of the extremely dire fiscal outlook. But there is perhaps a soft form of YCC is coming, and we will get details on Wednesday in the QRA announcement.
This MarketWatch article states:
“A long-awaited program intended to make the Treasury market more liquid and resilient is expected to get off the ground in a matter of days.
It is known as a buyback program and is scheduled to be reintroduced for the first time in more than 20 years. The U.S. Treasury has already conducted limited buyback tests this month and indicated that it will announce the date of its first regular operation as part of next Wednesday’s quarterly refunding announcement.
The goal of the program is to support liquidity in the world’s largest market for government securities. The U.S.’s growing debt pile is being seen by traders and strategists as one of the biggest catalysts for a prolonged period of volatility inside the $27.5 trillion Treasury market.”
The way that a buyback program can help control yields is by reducing the supply of off-the-run or previously auctioned or sold bonds, thereby increasing demand for newly issued bonds. If I am a pension manager who needs to maintain $1 million in long-duration U.S. Treasurys and I already own $1 million worth, then I won’t be buying more. But if the Treasury buys back $100,00 of my existing bonds, I have $100,000 to buy new bonds at the next auction.
In the next section, I will explain another soft form of YCC that is already here. In Section IX, I will tell you what I think about this. And then in Section X, why you should care and, more importantly, what more you can do about it. However, I have just hit a new paid subscriber threshold, so you must now be a paid subscriber to view the last three sections. The X Project’s articles always have ten sections. Soon, after a few more articles, the paywall will move up again within the article so that only paid subscribers will see the last four sections, or rather, free subscribers will only see the first six sections. I will be moving the paywall up every few weeks, so ultimately, free subscribers will only see the first four or five sections of each article. Please consider a paid subscription.
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