When bond yields rise, bond prices fall. Over the past 10 years, people buying US, European and Japanese government bonds have made gains most of the time. This is because the respective governments have played the role of a last buyer. Consequently, the bonds could hit a record high not long after having set a new record, while the bond yields could become negative after hitting zero. Since governments sought to rescue the economy through quantitative easing, two problems have arisen. First, the moral boundary of free market economy has been removed, as governments eventually will intervene to maintain market order. Second, quantitative easing is like drug abuse - when the size of debt grows, higher interest rates become less acceptable, or governments may go bankrupt. Therefore, short sellers of government bonds are never in a hurry. They know governments will eventually make a move, and they will make big gains.

If the GameStop controversy that erupted recently was a short squeeze drama, then the current bond market is an overt plot in which governments are there to ultimately come to the market’s rescue if needed. In this regard, the US is naturally the focus of attention. Even the average Joe in the dim sum restaurant in your neighborhood is aware of the sheer size of the US government’s debt. For sure there will be no repeat of the aggressive move of the US government in the 1980s to raise interest rates to 10 percent. Commenting on the situation recently, a composed Federal Reserve (Fed) Chairman Jerome Powell said it was not time for the Fed to act. In effect, he has got three aces placed face down, and he will wait for the right opportunity to play these cards.

The Fed has three tricks with which it can sort out the bond yield issue at any time. The first one is of course quantitative easing. The Fed is already selling US$120 billion worth of bonds every month. If it wants bond yields to go down, it will have to step up quantitative easing. But as mentioned before, using fiscal measures to rescue the market is an approach that replaces monetary policy to achieve the same objective. With such an approach, monetary policy is relegated to a less important role, and so even though bond yields rise again, the chances of the Fed stepping up quantitative easing are low.

The second trick is called Operation Twist. This is an approach that central banks in Europe have been implementing for a long time. It involves selling short-term bonds and buying long-term ones. After central banks have sold short-term bonds in return for funds, short-term bond yields will increase. The banks will then use the funds to buy long-term bonds, causing long-term bond yields to fall. In the process, no new money is printed. All it takes is to do something to the scale of the balance sheet, so that the yield curve is flattened. The chances of the Fed adopting this trick are the highest, as there is no need to ramp up quantitative easing while long-term yields can be pushed down.

Lastly, there is a trick related to yield curve control (YCC). This is a mastery of central banks that has not been used for 70 decades. YCC is also about buying bonds, but it is not the same as quantitative easing. It is about a central bank setting a target bond yield level. Then, the bond yield curve is controlled through the buying and selling of bonds with different maturity terms, until the target yield is reached. In terms of quantitative easing, no such target is set. It is all about buying bonds to push down bond yields, and quantitative easing will then be ramped up or eased based on the economic situation.

As YCC involves setting a target, it means a central bank will be able to reach the target. So naturally, people have the incentive to scramble for the first lot of gains. Consequently, the central bank will buy fewer bonds than it would in the case of quantitative easing. That helps to prevent the Fed’s balance sheet from growing too fast. In 2016, the central bank of Japan adopted the YCC approach. Eventually, the size of the bonds purchased that year was smaller than the total amount bought between 2013 and 2016 when quantitative easing was implemented. Although YCC implies a central bank is the one to rescue the market ultimately, there is a bottom line and, therefore, the market will not expect the central bank to take over government bonds after the bonds have been snapped up in the market to a level that bond yields hit a negative level. Both Ben Bernanke, former Fed chairman, and Janet Yellen, current US Secretary of the Treasury, have suggested that the Fed consider adopting YCC. The US only used this trick between 1942 and 1951, and it proved highly effective. Nevertheless, that was an isolated case. That period covered the few years after the end of the Second World War and everything in the country had to be rebuilt. It is only when quantitative easing does not work that YCC will be considered.

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