Are negative rates headed for the US?
Are negative rates headed for the US?
We examine the evolution of negative interest rates globally and discuss the prospects for negative rates in the US.
The 2008 global financial crisis was the catalyst for global central banks to cut short term interest rates to zero and resort to unconventional policy measures, eventually including negative interest rate policy (NIRP). More than a decade later, short term interest rates have remained low in many countries and some major central banks still operate under negative interest rates.
Negative rates were viewed as the last resort to boost economic growth after all other options failed. They were implemented in Sweden in 2009 and Demark in 2010, followed by the Bank of Japan (BoJ) in 2016 and the European Central Bank (ECB) in 2014. The ECB reduced its negative policy rate even further in September. One way NIRP was intended to stimulate the economy was by requiring banks to pay interest for holding excess reserves with the central bank. This interest “penalty” was supposed to disincentivize banks from holding excess reserves and instead incentivize them to lend more, in theory boosting economic activity.
In 2014, 10-year German bunds yielded around 1.4%. The yield curve was hence very steep, indicating that the market perceived that such low rates would be a temporary phenomenon - the perception was that zero was the effective lower bound for interest rates. Negative rates were still an untested policy tool and much academic debate raged about the risks associated with such a move.
Fast forward to today, and interest rates are still negative in the eurozone, Switzerland, Sweden, Denmark and Japan. However, negative interest rates have had limited success in sparking inflation. Fortunately, many of the concerns raised at their inception have not been realized to a significant degree and the financial systems in these countries have adjusted to the new reality in an orderly way. Markets no longer perceive low rates as temporary and yield curves indicate that we will likely not return to pre-crisis levels of interest rates for generations. Zero is no longer seen as the lower bound and negative policy rates are accepted as mainstream among central banks as part of their toolkit.
In addition to using negative rates as a policy lever, global central banks have embarked on significant balance sheet expansion and asset purchases, including the purchase of negative yielding debt. Countries that at points in the last decade were viewed as credit risks (such as Portugal and Italy) now find themselves being paid to borrow money. High quality corporate issuers have also found themselves able to issue at negative interest rates in Europe.
These shifts have had a meaningful impact on global fixed income markets. The US dollar value of negative yielding securities within the Bloomberg Barclays Global Aggregate Index currently stands at around USD14 trillion (albeit off its recent peak of USD17 trillion).
What are the prospects for negative rates in the US?
In the US, the Trump administration has urged the US Federal Reserve (Fed) to aggressively reduce interest rates to zero, or less, leading to speculation about whether negative rates could be implemented in the US. Furthermore, the flatness of the US Treasury curve has raised questions about the Fed’s ability to effectively conduct quantitative easing (QE) or otherwise manage the shape of the yield curve (e.g. Operation Twist), sparking discussion and speculation over whether negative rates could provide the Fed with more room to maneuver.
There are a few reasons why we do not believe the US is likely to see negative interest rates. First and foremost, the US economy has not slowed enough to justify zero interest rate policy (ZIRP) or NIRP, in our view. Second, the runway to negative rates in the US is long. In other words, the Fed has enough tools designed to ease credit conditions and ensure market functioning in the next downturn before resorting to NIRP. For example, open market operations (buying and selling government securities) has, historically, been the Fed’s most flexible and commonly used tool to control monetary policy. These operations allow the Fed to control the supply of banks’ reserve balances, indirectly controlling the movement of short-term interest rates. Only the sale and purchase of government securities are allowed under the law that governs the Federal Reserve System. While we believe a change in the law is unlikely, Congress could allow the purchase of non-government securities to expand QE,1 which could potentially be contemplated before implementing negative rates.
Just to reach to ZIRP, the Fed would need to cut interest rates by 175 basis points from the current target range for the federal funds rate of 1.75%-2.00%. Once ZIRP is in effect, the pathway to NIRP would entail negative rate bidding in Treasury bill auctions, which would likely cause a suspension of the Fed Reverse Repurchase Program due to the inability to conduct negative auctions. Interest on excess reserves would likely halt and banks would likely be penalized for holding excess reserves. Other disruptive and undesirable ramifications of ZIRP and NIRP are low bank profitability and the adverse impact on the normal mechanics and functioning of financial markets.
With US growth holding steady at around 2% per year and inflation relatively contained it would seem the current low interest rate environment has not led to the robust credit expansion intended to cause inflation to accelerate. Likewise, a negative interest rate environment would not be guaranteed to successfully stimulate the economy. We believe being cognizant that the Fed could employ NIRP as a policy option is prudent, but we do not view it as a likely scenario, given the current benign state of the US economy, the uncertainty over its effectiveness and the range of other tools available to the Fed on the path to negative rates.
This article was first published in the Global Fixed Income Strategy for September 2019. Thomas Sartain is Senior Portfolio Manager at Invesco Fixed Income. Marques Mercier is Head of Government and Municipals, Global Liquidity at Invesco Fixed Income.
^1 Open market operations are governed by the Federal Reserve Act of 1913 which defines the purpose, structure, and function of the Federal Reserve System. The law states that any purchased security must be either a direct obligation of the US government or a US agency, which disqualifies non-government bonds. Only Congress has the power to amend the Federal Reserve Act.
- Global Fixed Income Strategy - September 2019
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