Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Steer the Yield Curve
Transcript
- Lucas: So in March of 2024, the Bank of Japan did something that a lot of market observers thought they might never be able to pull off. They ended their yield curve control program — the YCC — after nearly eight years of capping the 10-year Japanese government bond yield at a hard ceiling. Luna: And just to be clear, YCC is not the same as quantitative easing, right? It's more specific. Lucas: Exactly. QE is about the quantity of bonds you buy. YCC is about the price — the yield. You say 'I will buy unlimited amounts of this specific bond to keep its yield from rising above X percent.' The BOJ started in September 2016 with a 10-year yield target of around zero percent, and then later shifted to a 0.25 percent cap. Luna: And the idea was to keep long-term borrowing costs low to encourage spending and investment, while also steepening the curve enough to keep banks profitable. Lucas: Right. The BOJ wanted to flatten the curve at the short end but let the long end rise a little. In practice, though, they ended up defending a ceiling. And that ceiling came under massive attack in 2022 when global inflation spiked and the Fed started hiking aggressively. Luna: So the BOJ is trying to hold JGB yields at 0.25 percent while U.S. 10-year yields are pushing toward 4 or 5 percent. That pressure differential must have been enormous. Lucas: Enormous is an understatement. In June 2022, the BOJ had to buy over 16 trillion yen worth of JGBs in a single month just to defend the cap. That is about 120 billion dollars. And they kept buying — they ended up owning more than half of the entire JGB market by 2023. Luna: It is a brutal game of whack a mole. Every time yields try to break the ceiling, the central bank has to step in, but the more bonds they buy, the more they crowd out private trading and distort the market. Lucas: And that distortion became a real problem. By late 2022, the JGB market was barely functioning. Dealers couldn't hedge, pension funds couldn't rebalance, and the BOJ's balance sheet was ballooning. They had to adjust the band twice — first in December 2022, widening the 10-year ceiling to 0.5 percent, then in July 2023 to 1 percent, which they called a 'reference,' not a cap. Luna: Semantics, really. The market knew they'd still defend it if it got too close. Lucas: Exactly. And the big question all along was: how do you exit this without blowing up the bond market? Because once you signal that you might stop buying, yields could spike instantly, and you lose control. That's exactly what happened in the UK with their gilt crisis in 2022 — they announced a mini-budget, the market panicked, and the Bank of England had to step in with emergency purchases. Luna: But the BOJ managed to engineer an exit over the course of about six months, starting in October 2023. They gradually reduced their bond buying and gave the market time to price in the new reality. Lucas: Yeah, they were smart about it. They stopped making explicit yield targets but kept buying bonds at a declining pace. And importantly, they had an inflation narrative to support the move. By early 2024, Japan's core CPI was running above 2 percent for over a year — so they could argue that YCC was no longer needed because deflation was defeated. That gave them cover. Luna: Still, it's risky. You're essentially telling the market 'we're taking away the training wheels.' And if the market overreacts, you lose credibility. Lucas: And that's the central tension with YCC. It works brilliantly in theory when inflation is low and markets are calm. You set a ceiling, you barely have to buy anything because nobody challenges it. But as soon as the macro environment shifts, you become the only buyer in town, and your balance sheet grows without bound. Luna: Let's talk about other central banks that tried this. The Reserve Bank of Australia had their own version in 2020 — they targeted the three-year yield at 0.25 percent. Lucas: Right, the RBA's yield target. It was supposed to be a temporary tool to support the economy during COVID. But they made a critical error in November 2021. They had been signaling that the first rate hike wouldn't come until 2024 at the earliest, but inflation data surprised to the upside. The market started testing the 0.25 percent ceiling on the three-year, and the RBA defended it — they bought bonds — but then a week later they suddenly abandoned the target. Luna: Ouch. That must have hurt their credibility. Lucas: It did. The RBA governor at the time, Philip Lowe, later admitted that the yield target was a mistake. They had communicated it as a firm commitment, but when market conditions turned, they couldn't sustain it without buying huge volumes. They ended up buying about 50 billion Australian dollars in government bonds just to defend a target they then abandoned. It was a textbook case of how quickly YCC can go wrong. Luna: And the U.S. had Operation Twist back in 2011, which was like ycc lite. The Fed bought long-term bonds and sold short-term bonds to flatten the yield curve without expanding its balance sheet. Lucas: Exactly. Twist was sterilized — they weren't adding net reserves. So it didn't have the same explosive balance sheet dynamics. But it was still an attempt to influence the term premium, the extra yield investors demand for holding longer-dated bonds. And the evidence suggests it worked modestly — maybe 15 to 20 basis points of compression. Luna: So when does YCC make sense? Is it ever a good idea, or is it always a trap? Lucas: I think there's a case for it in a crisis, as a temporary backstop. The Fed effectively did YCC during World War II, when they capped long-term Treasury yields at 2.5 percent to keep war financing costs low. But that was a different era — capital controls, financial repression, and a captive audience of banks and insurers. In a modern, open capital market, YCC is incredibly fragile because there's no natural floor unless the central bank is willing to print unlimited money. Luna: And even then, the distortion gets worse over time. The BOJ held the 10-year yield below 1 percent for years while nominal GDP growth was running around 3 to 4 percent. That means real yields were deeply negative, which discourages saving and encourages risk-taking in other assets — like the Nikkei hitting 30-year highs. Lucas: Right, and that's not necessarily bad if your goal is to reflate the economy. But the BOJ's own studies showed that YCC reduced the volatility of long-term yields but also reduced market liquidity. By 2023, the JGB futures market had seen trading volumes drop by over 40 percent from pre ycc levels. That's a real cost. Luna: I want to bring this back to the current environment in June 2026. We've seen central banks in Europe and the U.S. cutting rates over the past year, but long-term yields have been sticky. The ten-year Treasury is still around 4.2 percent even though the Fed funds rate is below 4. Does that suggest the Fed has lost some control over the long end? Lucas: It's a good question. The Fed doesn't target long-term yields directly anymore, but they do influence them through forward guidance and QE expectations. Since the pandemic, the term premium has been positive again — investors demand compensation for inflation and fiscal risk. So even if the Fed cuts short rates, long rates can stay elevated if the market thinks deficits will keep growing or inflation will re-accelerate. Luna: So YCC is off the table for the Fed, then? Lucas: I think so. For now. The 2011 Twist experience and the BOJ's ordeal have made central bankers wary. The current Fed chair has been pretty clear that they prefer using rates and balance sheet tools separately. But if another crisis hits—say, a sovereign debt crisis in a major economy—YCC could come back as an emergency measure. The toolbox is still there. Luna: Speaking of tools… you know, this kind of deep dive into how central banks actually operate is exactly the reason a lot of listeners tell us they appreciate the show. It's ad-free, and we get to spend as much time as we need on a single idea. Lucas: Yeah, and the way we keep it that way is through listener support. If you get value out of episodes like this, you can toss a few bucks our way at buy me a coffee dot com slash fexingo. It genuinely makes a difference. Luna: Absolutely. Every contribution helps us keep the research time and the independence. So thank you to everyone who already does. Lucas: Okay, back to the yield curve. One last concept I want to touch on is the idea of a 'curve steepener' trade. When the BOJ abandoned YCC, a lot of hedge funds had been betting on that move—they had short JGB futures, expecting yields to rise. That's a classic convergence trade. And when the BOJ finally blinked, those positions paid off massively. Luna: So the market was basically betting against the central bank, and the central bank eventually had to cave. Lucas: Right. And that's the ultimate lesson: YCC is only as credible as the central bank's willingness to print unlimited money. The moment the market senses a limit—whether it's a political constraint, an inflation constraint, or a balance sheet constraint—the ceiling becomes a target. The BOJ managed to exit gracefully, but it came within a hair of losing control in 2022. Luna: So what's the takeaway for investors? If you think a central bank might adopt YCC, or if you're in a country that already has it, what should you watch? Lucas: Watch the inflation data and the central bank's communication. If inflation is rising and the central bank is still defending a yield cap, that's a sign of strain. Also watch the foreign exchange—if the currency is weakening sharply, it often means the market is losing confidence in the policy. For Japan, the yen fell to 150 against the dollar in 2022, which was a huge signal. And finally, watch the central bank's own projections. If they start revising inflation forecasts up, the endgame is near. Luna: So YCC is not dead, it's just dormant. It will come back in some crisis, somewhere. Lucas: I think that's right. The BOJ's experience didn't discredit the tool—it just demonstrated the conditions under which it works and the conditions under which it breaks. And that's valuable knowledge for any central banker—or any investor—watching the next crisis unfold.