ECB Is Capping Bond Yields But Don’t Call It Yield Curve Control

(Bloomberg) -- The European Central Bank is emulating its Asia-Pacific peers by controlling government borrowing costs, just in a uniquely European way.

The ECB is buying bonds to limit the differences between yields for the strongest and weakest economies in the euro zone, according to officials familiar with the matter, with one person saying the central bank has specific ideas on what spreads are appropriate. An ECB spokesman declined to comment.

Investors have long wondered whether the central bank has specific levels in mind when it tries to cap bond yields. The latest insight into its strategy sheds light on how policy makers are navigating euro-area complexities that make publicly targeting bond levels difficult.

Sovereign yields are key to fighting the pandemic crisis. Not only do they influence all other loan costs, but keeping government borrowing affordable has become a critical part of monetary policy as companies and workers rely on massive, debt-financed fiscal support.

The ECB’s strategy explains why the spread between Italian and German debt has stayed remarkably stable despite the Italian government nearing collapse, after the central bank raised the pace of bond buying. Rates volatility is at record lows, according to Tanvir Sandhu, chief global derivatives strategist at Bloomberg Intelligence.

It’s different to the so-called yield curve control deployed by the Bank of Japan and Reserve Bank of Australia, which have publicly announced numerical targets for specific yields. In the case of the BOJ, it aims for zero percent on the 10-year government bond.

ECB President Christine Lagarde, who convenes the first policy meeting of the year on Thursday, doesn’t have that luxury. She has to manage the monetary needs of a currency union with 19 nations, each issuing their own debt.

Right now, that means pledging to lock financial conditions in place through the crisis. Those conditions are broadly defined, including “all private and public sectors of the economy, comprising interest rates as well as credit volumes and conditions,” according to the account of December’s policy meeting.

While that strategy is similar to yield curve control, “they’re calling it something different,” said Christoph Rieger, head of fixed-rate strategy at Commerzbank AG. “My feeling is that this is an important thing for the ECB, they’re looking at it and they’re actually envious of the BOJ. They would love to have something like that.”

Yield curve control has caught on as central banks delve deeper into their toolkits after cutting interest rates to record lows and unleashing trillions of dollars in bond-buying. In theory, it’s cheaper than quantitative easing alone because investors are essentially told not to fight back.

The BOJ adopted the policy in 2016 as a stimulus tool to boost inflation. The RBA decided last March to keep three-year yields at around 0.25%, and in November reduced that to around 0.1%. U.S. Federal Reserve Vice Chair Richard Clarida said late last year it’s part of the toolbox.

The pledge has to be credible though. Investors must believe the central bank will spend as much as needed to defend its policy, and that’s where the ECB runs into problems.

For starters, it lacks a single bond to target. That’ll change soon when the European Union starts issuing joint debt to finance its 750 billion-euro ($909 billion) recovery fund, but that plan is a temporary one linked to the pandemic -- the ECB could run out of bonds to buy.

The central bank is also forbidden by EU law from directly financing governments. It has kept its bond-buying programs legal by imposing limits on what it can buy and for how long, but yield curve control is implicitly limitless.

“There are a number of issues in opting for such a strategy, or adding this to the ECB toolbox,” said Katharina Utermoehl, an economist at Allianz SE. “This could bring out the idea that actually the ECB is doing monetary financing.”

The central bank hasn’t rejected yield curve control, and Bank of Spain Governor Pablo Hernandez de Cos said this month that it’s an “option worth exploring.”

Hernandez de Cos suggested targeting a technical measure, the region’s overnight index swap curve. Economists including ABN Amro’s Nick Kounis have proposed using an average euro-zone bond yield weighted by national gross domestic product.

Both Hernandez de Cos and Executive Board member Isabel Schnabel say the Governing Council has never discussed formal yield curve control.

The measure does carry broader risks, such as encouraging reckless fiscal policy by relieving governments of some market constraints.

The Fed and the U.S. Treasury agreed in 1942 to cap borrowing costs to fund the country’s participation in World War II. Five years later, inflation was in double digits amid the post-war boom and the central bank was forced to start pulling back.

Explicit yield goals also make exiting the policy a challenge. Investors are likely to dump bonds, driving up borrowing costs, the moment they perceive the target is about to be dropped.

That may ultimately mean the ECB has an edge with what Lagarde has described as an “holistic” approach to maintaining favorable financing conditions.

“It’s not as explicit as the Japanese do it, but broader,” said Florian Hense, European economist at Berenberg. “Once it’s out that you explicitly control the yield curve, this commitment can be very expensive.”