Yahoo Finance's Brian Cheung joins the Yahoo Finance Live panel with today's Yahoo U: Yield Curve Control

Video Transcript

ZACK GUZMAN: Inflation expectations continue to run hot. And today, the yield on the 10-year briefly hit 1.62%. What might the Fed do to react to all that? And what kind of pressure are they facing here? It's got a number of tools at its disposal. And one we've been hearing a lot about recently, that would be a yield curve control. But what does that even mean? Here to break that down for us in today's Yahoo U is accredited TV professor Brian Cheung. Brian?

BRIAN CHEUNG: [LAUGHS] Hi, Zack. Well, class is in session. And if you caught our Yahoo U last week, you learned that bond yields are highly correlated and a proxy essentially for interest rates. So higher longer term interest rates mean more expensive longer term business loans, more expensive 30-year mortgages.

But the Fed can do something about this through a tool called yield curve control or YCC. But first we need to take a step back and think about the Treasury market. And remember that US government debt comes in all sorts of duration. They can come as cute as three-months-old to as ugly as, well, a few years off from 30 years. I'm not quite 30 years yet.

But obviously, the longer that you're going to hold onto the bond, the greater yields you're going to be compensated to to hold on to what they call that duration risk. So if you plot out the yield on all of these treasuries, you should tend to see an upward-sloping line like this. And that is indeed what this looks like.

So this is the yield curve, which I'm sure you've heard about in the past. And what I've taken here is I've taken the snapshot of the yield curve on two different days. So in blue is yesterday, March 4. And in purple is two months ago, January 4.

And you can notice the blue curve is much steeper than the purple curve. And that's because of, obviously, the rise in longer dated bonds. If you look at the 10-year, for example, Zack, you were just saying that it's above 160 basis points. That's over 60 basis points above where we were about two months ago.

So again, bond yields are proxies for interest rates. So if 10-year borrowing costs are rising, the Fed might say at some point, well, maybe that's bad, at which point they could do something like, well, buying enough bonds until those borrowing costs come back down. If they did that, this will be called yield curve control.

So here's an example of how the Fed might do this in practice. What you're looking at here is the three-year US Treasury. This is plotted over the last six months. And the Fed will pick a number, let's say hypothetically 10 basis points. So I'm going to draw a straight line there. That looks relatively straight.

If it takes one bond to get this down to 10 basis points, that's great. If it takes $20 billion in bonds to get it down to that point, also great. That's what it's going to take to get it down to that 10-basis point target.

Now the question you might have is, well, why three years? Well, think about if the Fed wanted to do a 10-year bond. They'd have to commit to doing that for 10 years. And that's a pretty serious commitment if you ask me. I mean, even three years is a pretty serious commitment right there.

But one Reserve Bank that did want to do what they call a medium term commitment is the Reserve Bank of Australia. So let's go down to the land down under. This is the three-year Australian government bond yield. And in March last year, they did something very interesting. They said, we're going to have a yield curve control policy that targets a 25-basis point target on the three-year government bond. And that's exactly what happened.

Notice how it fluctuated a little bit. But for the most part, it's right there on the money at about 25 basis points. Makes sense. The Reserve Bank is going in there and buying these bonds. In November, they did it again. They actually lowered that target from 25 basis points to 10 basis points.

So the question here is did this policy help them flatten the curve? Uh, mixed results. So this is a chart of the 10-year. So again, we went from the three-year. We're looking at the 10-year now.

The Australian 10-year bond is in purple, whereas the 10-year US Treasury is in blue. So if you think we've been talking about 10-year bonds rising higher, the Australian bond has gone up even more than that, despite their yield curve control policy.

The Reserve Bank of Australia, as a result of all this, had to get more aggressive with their bond purchases to get those yields back down. So an interesting dynamic here. And as I wrap up here, this is not all to suggest that yield curve control is a failure, for example.

And we've talked about this before. There are a number of different reasons for why bond yields can go up or down. It's kind of like an avant-garde movie or a wild horse. You really don't know why it's going in which direction.

But what's interesting is the Fed has been pretty clear that they don't want to do this right now, although it is a tool on the table. That's what Philadelphia Fed President Patrick Harker said. So it could be just the Fed saying, well, we have this button that we can push if we need to use it, which maybe that in and of itself will depress bond yields. But very interesting all of that right there, worth watching as we head into that next Fed meeting in about a week and a half. But that, [CHUCKLES] is our lesson. Class is dismissed.

- I do love a good conversation on YCC. Brian bringing us that lesson for this week's lesson for Yahoo U.