Happy Holidays!

I will be off until early January. Merry Christmas, and a Happy New Year!

Yield Curve Control Blues

The Bank of Japan surprised people with a change to its yield curve control (YCC) policy. This has caused a mild sell-off in Japanese bonds, with the 10-year Japanese Government Bond (JGB) yield up 15 basis points on the month when I last checked.

Although I think some of the usual suspects have tried to get excited about this — a harbinger of doom to Japan and/or the global fixed income complex! — this is still in nothingburger territory. (Note: people who discuss bond yield changes as a percentage of previous yields — e.g., “bond yields rose by 100%!” when the yields go to 0.2% from 0.1% — are innumerate clowns and are safe to ignore.) Nevertheless, if the yield cap was raised by a lot more, there would be a lot of wailing and gnashing of teeth.

One standard dodge of a forecaster is to say that this might be important for global bonds. This makes one sound like a very serious forecaster with an eye on those darned black swans. However, any number of things can cause global bond yields to rise. If you want to be a yield forecaster (I don’t!), at some point you have to put your money where your mouth is and either recommend long/short positions and/or option strategies (if you want to position for tail risks). Although I am not a forecaster, I see no reason why I would change any non-Japanese market views as a result of these recent events.

Achilles Heel Of YCC

Yield curve control is a popular discussion point, particularly for Modern Monetary Theory types. My view is straightforward: yes, the government can make yield curve control stick. The problem with the policy is when the yield target is revised.

With short rate targeting, the central bank is not directly causing capital gains and losses for bond holders. Sure, they cause carnage, but they have plausible deniability: bond yields are set in the market, we are just setting the overnight rate! Sure, it’s stupid, but plausible deniability is still plausible deniability. On the other hand, with yield curve control, the central bank is directly handing out mark-to-market losses to widows, orphans, and pension fund bond managers. That’s a pretty potent political coalition burning you in effigy on the steps of the central bank’s main office.

It is also a financially unstable policy. A short-rate pegging regime works because forwards represent a market-clearing level in the private sector. Only an academic or central banker would be delusional enough to believe that central bankers can plant “expectations” where they want by announcing shifts to their views. In reality, the forwards represent the average guess as to how wrong the central bank’s forecast it. Once the central bank starts planting forwards by decree, market participants only have it a “take it or leave it” decision. If the forwards are too low, they dump bonds en masse — also known as an attack on the yield peg.

Needs Institutional Support

Anyone who has been paying attention to central banks has noticed several allegedly “permanent” self-imposed policy regimes by central banks over the past few decades (being a more detailed regime than the looser statutory inflation-targeting regime), each being abandoned whenever it became inconvenient. The lesson is that the only credible monetary policy regime is one that is backed by statute.

That is, the only way yield curve control is going to be a stable long-term policy is that it has to be set by law — and the rest of economic policy needs to be coherent with the policy. My view is that we are nowhere near a situation where policy is coherent with YCC, which is why I am not enthusiastic about the policy.

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(c) Brian Romanchuk 2022

Quick Indicator Comments

I just wanted to make two quick comments about data in the United States. The first is about a new rent series from researchers at the Cleveland Fed, the second is about labour data.

New Rent Index Data

Brian Adams1, Lara Loewenstein, Hugh Montag, and Randal J. Verbrugge just published the working paper “Disentangling Rent Index Differences: Data, Methods, and Scope.” URL: https://www.clevelandfed.org/publications/working-paper/wp-2238-disentangling-rent-index-differences. I did not have time to look over the paper, but the graphs are consistent with the story I have seen elsewhere: the rental data used in the CPI lags behind the latest changes, and the latest changes point to a lower growth rate in rent hikes.

Lagging Economic Indicator Still Lagging

My feeling is that although it is too early to declare victory over high inflation rates, I think we are closing in on closer to “normal” dynamics — by the standards of the post-1990 era. I believe that there are still areas of stronger pricing power, but some of the excesses have been unwound, so that we end up with more mediocre inflation prints. At least we would if the housing component of CPI — constructed to be a very slow-moving series — settles down. The market rent series that I have seen (but I do not have access to) suggest that it will settle down, but that will be a mid-2023 story.

The chart above shows the 6-month annualised rate-of-change of the “commodities” (goods) component of the U.S. CPI. It excludes housing, and is currently near typical levels seen in past cycles. Nothing that looks like a persistent inflation problem, but we cannot completely rule out more supply chain disruptions.

My guess is that we will back to more typical dynamics, where inflation follows aggregate demand with a lag, and business cycle sentiment indicators will be the ones to watch.

This mild inflation print adds to my confidence that it makes sense to wrap up my inflation manuscript. I will not be able to definitively say that inflation will revert to its post-1990 behaviour of bouncing around its target level, but we do not see inflation marching straight up at the end of the chart, which obviously would raise questions from readers.

Crypto: A Totally Non-Surprising Surprise

Criminal charges have been laid in the “FTX Scandal,” hopefully ending a remarkably stupid news cycle. Since I respect the convention of the presumption of innocence, I will not assume that anyone involved is guilty of what they have been charged of. That said, the charges make clear that some very questionable transactions were undertaken by somebody.

I have seen a lot of second-guessing of how the authorities dealt with the situation. I have no expertise in the legal tactics, but I believe they followed the right strategy. Which was to keep crypto at the margins of the financial system, and let the frauds burn themselves out.

This strategy was costly for the small accounts who followed dreams of easy money to end up getting their crypto investments wiped out. However, that was largely inevitable. Nobody had the political capital or will to properly regulate the industry, as even central bankers ended up legitimising the industry by their embrace of central bank digital currency theorycrafting. Meanwhile, regulations would have been easily evaded — and that evasion would have been cheered on.

I see no evidence that anyone has really learned anything from recent events, as we instead see attempts of crypto supports to blame the FTX collapse on the government. Instead, the main risk to the crypto industry is cascading liquidity events as investors attempt to withdraw money. That is a fairly typical reaction to a popping bubble. The core of the crypto system can survive, but the leveraged appendages that drove up crypto asset prices are at risk.

In any event, the lack of contagion to the rest of the financial system confirms that crypto has no macroeconomic significance.

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(c) Brian Romanchuk 2022

Currency Swap Comments From The BIS

Claudio Borio, Robert McCauley, and Patrick McGuire solved the problem about what I will write about this week by publishing “Dollar debt in FX swaps and forwards: huge, missing and growing” as part of the Bank of International Settlements’ quarterly review (https://www.bis.org/publ/qtrpdf/r_qt2212h.htm). One can interpret the text as a plea for more data, which is reasonable enough. However, the lurid headlines and commentary that the article has attracted elsewhere is somewhat missing the point. I am not attempting to discuss that article in depth, rather offering my interpretation of the underlying issues.

Banks, Securities Markets, And Risk

Large bank corporations now tend to have both traditional lending divisions as well as securities market divisions. This was not always the case; regulators used to keep financial firms locked to specialisations — this was referred to as “the pillar system” in Canada. However, ongoing deregulation eroded the pillars — I discuss part of the economic logic below. It is possible to find banks that stick to a traditional loan/deposit structure (particularly in the United States, with a highly fragmented banking system), but those banks tend to be smaller.