The Fed isn’t just constrained in its capacity to deploy conventional easing to combat a downturn and keep financial conditions loose, but also in its ability to resort to unconventional measures.
That’s the message from BofA’s Mark Cabana, and the rationale is quite simple. Obviously, rate cuts (i.e., conventional easing) are limited by the proximity of the lower bound. When it comes to unconventional easing, it’s the yield curve that’s the problem.
“On the surface, the Fed appears to have many options for unconventional easing [and] this is especially true considering the Fed could employ enhanced forms of forward guidance”, he writes, in a note dated Wednesday. “However, the Fed’s easing playbook is somewhat curtailed if the yield curve remains flat”.
Because QE and Twist operated by lowering long-term rates, deploying those measures when the curve is flat risks perpetuating inversion pressure, and thereby stoking recession concerns.
Cabana cites Fed research showing that post-crisis balance sheet policies had the effect of lowering 10-year US yields by some 100bp. “If fed funds reach zero in coming years a similar-sized unconventional easing would risk inverting the UST curve”, he writes, adding the obvious, which is that “the Fed likely has no interest in pushing the yield curve into inverted territory since it signals concerns over the longer-run growth outlook and creates financial intermediation and profitability concerns for banks and pensions”.
Clearly, the curve doesn’t need any help flattening. Between growth concerns, plunging inflation expectations, persistent pressure on neutral rate estimates and term premia spillovers from abroad (see the figure), the 2s10s inverted last month, and there are plenty of good reasons to believe the bull flattening pressure will likely overwhelm any bull steepening impulse from Fed cuts.
BofA goes on to write that the market is pricing 35bp for the 2s10s curve 2Y forward. “These expectations imply a very limited amount of steepening with the 2Y forward 2Y rate priced at 1.3%, but assume the Fed will not need to take its policy target all the way back to zero”, Cabana says, on the way to warning that with “almost five of the remaining eight 25bp cuts fully priced by early 2021, it is difficult to see how the last remaining cuts will succeed in steepening the curve when first series of eases failed to do so”.
And besides, even assuming 2Y forward 10Y stays put and the 2Y forward 2Y drops to zero, that still wouldn’t compute to a 2s10s curve that’s as steep as it was when the Fed deployed QE and rolled out Operation Twist.
What does it all mean? Well, it presumably means the Fed will be forced to consider alternative or, “outer rim”, options.
“If the Fed cuts rates to zero and faces a flat curve, we see risk it rapidly exhausts its other unconventional monetary policy tools to more seriously consider ‘outer rim’ easing options [including] having to concentrate balance-sheet expansion on agency MBS and more seriously consider new easing options such as yield curve control, ‘MBS vs UST twist’, and potentially negative rates”, BofA says.
Of course, those options come with all kinds of risks. With YCC, the Fed could end up in a situation like the Bank of Japan is in now, where they’re forced to defend the lower (or upper, for that matter) range for yields or risk losing control and thereby credibility. On an MBS versus UST twist, the central bank’s convexity risk goes up. And as far as negative rates go, the Fed would be exposed to all of the familiar NIRP criticism that the ECB and the BoJ are currently facing.
There is one other option, though. “Congress [could] amend the Federal Reserve Act to allow for the purchase of non-government guaranteed assets”, Cabana muses.