Will the US Fed resort to negative rates?

We are living in interesting times. A pandemic has forced us to work from home (those who have work are fortunate) and has limited our social interaction to a bare minimum. Global economy is in a recession and many industries (airlines, hospitality and retail to name a few) are operating at single digit capacity. The impact of Covid-19 is colossal across the real economy and I expect that the after-effects will be felt for many years in the form of deflation, high unemployment, business closures and debt defaults. While real economy continues to be under a heavy cloud, financial markets have made a strong recovery since that brutal month of March. We saw the fastest move into a bear market in March - from February 19 through March 23, S&P 500 fell by ~ 34%, and then an equally speedy rebound in April. At 2,954 (18th May closing) level, the S&P 500 is 32% above its March 23rd low of 2,237. The MSCI World Index has also rebounded from March lows and has gained over 28% in the same period. We also saw oil prices (WTI) crash below zero and went as low as -$40/bbl on 20th April (albeit for purely technical reasons). Since that eventful day, oil prices have recovered sharply and are now trading at around $32/bbl for WTI and $34/bbl for Brent. Global central banks and governments acted fast and announced one stimulus package after the other to calm the financial markets and support the economy. In terms of policy action, the US Fed took the lead and announced multiple emergency rate cuts in March, taking the Fed Fund Target Rate to 0%-0.25%. The Fed also announced its intention to purchase unlimited amount of US Treasuries and Mortgage backed Securities to support smooth functioning of markets. The Fed did not stop there and decided to use its emergency authority under Section 13(3) of the Federal Reserve Act to set up programs to lend to money-market funds, invest in municipal bonds, lend to main-street businesses, and buy corporate debt (both IG and HY) directly and indirectly through ETFs.

We have seen many firsts during this crisis and now financial markets are clamoring for yet another unprecedented move. For almost two weeks now, Fed Fund Futures contracts are pricing-in a negative interest rate by the Fed in second half of 2021. In other words, markets expect the Fed to follow the example set by others such as the BoJ, the SNB and the ECB and cut rates to a level below zero – which is the effective lower bound as of now. Financial markets are not alone in calling for negative rates. Some well-known economists have also come out in the support of negative interest rates in the US. Kenneth Rogoff who is a professor at Harvard University and is co-author of famous book titled “This Time Is Different: Eight Centuries of Financial Folly, recently contributed an article on Project Syndicate (a very useful source of scholarly information with brilliant articles and research papers) in which he has presented a case for deeply negative interest rates to fight deflation and defaults, and prevent cash hoarding by financial firms (banks, pension funds and insurance companies). His argument is that a deeply negative rate of say -3% will work in the same way as a cut in positive rates. He states - negative rates would lift many firms, states, and cities from default. If done correctly – and recent empirical evidence increasingly supports this – negative rates would operate similarly to normal monetary policy, boosting aggregate demand and raising employment. I will not comment on this aspect as I don’t have access to the empirical evidence, which Mr. Rogoff has referred to. He has made another point in his article, saying negative interest rates will act as a penalty on large cash hoardings by big depositors (financial firms as mentioned above). He advocates charging a fee from depositors by banks, who in turn will pay a fee to the central bank for maintaining reserves. This will discourage cash hoarding and encourage spending/investment. As we know in Europe, banks pay a fee (negative rate) on reserves maintained with ECB, but mostly don’t charge a fee from depositors. Can European banks follow Mr. Rogoff’s advice and penalize large depositors? I have my doubts as any such effort will lead to a large scale shift in deposits from European banks to banks based in jurisdictions. I will address the feasibility of charging a fee (negative interest rate) on reserves placed with the central bank in the context of USA later in the article.

I believe markets are getting a tad overexcited and this signaling for negative rates will not push the Fed to act. US interest rates will stay in the positive territory (at zero for the foreseeable future) and there are a few compelling reasons behind this view. I will discuss those reasons briefly.   

Chart 1: When at 1st Cut You Don’t Succeed Cut Again

Source: Bloomberg

Chart 2: Fed Balance Sheet reaches ~ $ 7 trillion

Source: TD Securities

1.     The Fed does not see Negative rates as an “appropriate policy” tool

Negative interest rates have been in practice for well over a decade now. The policy was first adopted by the Bank of Japan and post the global financial crisis in 2008, other major central banks such as the ECB and the SNB also resorted to negative rates to stimulate the economy. On the other hand, post 2008, instead of cutting rates below 0%, the Fed decided to resort to “Quantitative Easing” and deployed its balance sheet to ensure smooth market functioning and ease financial conditions. While jury is still out on the effectiveness of various rounds of QE, it is widely accepted that negative interest rates in both Europe and Japan did not yield the desired results, forcing the two central banks to start their own QE, which is still ongoing. According to a research paper (Evaluating Central Banks' Tool Kit: Past, Present, and Future by Eric Sims and Jing Cynthia Wu), a central bank’s policy is more effective if it first pushes policy rates into negative territory and then engage in QE programs. Secondly, implementing negative interest rates while running a large balance sheet (as a % of GDP) is ineffective and could become mildly contractionary as the balance sheet size grows. The Fed’s been there and done that – it adopted QE before going negative on rates. The Fed’s balance sheet is ~ 33% of GDP and is likely to grow to 40% by the end of this year. Therefore, I believe the Fed sees QE as an appropriate tool rather than resorting to negative rates. Fed Chairman Powell himself has stated the Fed doesn’t see negative rates as ‘appropriate’ policy for the United States. It’s unlikely that central bank will entertain negative interest rates as the next step to help the economy during the coronavirus scare. Instead, Mr. Powell said, the Fed is focusing on interest rates and other “liquidity tools” it is using to keep credit flowing and financial markets operating properly.

2.     Implementation mechanism of Fed’s monetary policy prevents negative interest rates

The Fed implements its monetary policy under an ample reserves regime and pays interest on reserves to the banks. The level of reserves in the system is critical in smooth functioning of the monetary policy. In a scenario where reserves are depleted (for any reason), the cost of borrowing in repo markets goes higher and the Effective Fed Fund Rate (EFFR) can approach or even cross the upper bound of the Fed Fund Target Rate (FFTR). This threatens the effectiveness of monetary policy. This is exactly what had happened in September 2019 and forced the Fed to start buying huge amount of treasury bills to ramp up reserves in the system. If the Fed adopts a Negative Interest Rate Policy (NIRP), it will start charging a fee on these reserves, which as of last week were in excess of $ 3 trillion. Banks will rather withdraw reserves, leading once again to a situation of reserves scarcity, which will put upward pressure on borrowing costs and hinder credit expansion. There is another hitch - the Fed pays interest on reserves under a law – Financial Services Regulatory Relief Act of 2006. The law says that depositors “may receive earnings” and does not contemplate the charging of fees (negative interest rate). Therefore, in order to adopt a NIRP, the law needs to be amended by the US Congress. Given the fair amount of backlash against the financial sector (big banks) and political sensitivity involved in passing an amendment to allow charging of fee on deposits, I don’t think the Fed will approach the US Congress for any such amendment. Fed Chairman Jerome Powell had highlighted this in a testimony in February: 

“Going forward, our inclination would be to rely on the tools that we did use as opposed to negative rates. When you have negative rates, you wind up creating downward pressure on bank profitability, which limits credit expansion.” 

Chart 3: Excess Reserves Rising Sharply Amid QE and Fed Facilities

Source: TD Securities

3.     Significant Size of Money Market Mutual Funds in the US

US Money Market mutual funds, with assets of $4.5-$5 trillion play an important role in the US financial system. The investors in these funds (especially the government securities focused) treat them like bank accounts and don’t anticipate a situation where the value falls below $1 (the face value) – the dreaded “breaking the buck” episode of 2008 is still very fresh in our minds. The Fed is concerned that negative returns in these funds due to negative interest rates could spark a market panic and a liquidity crisis.

Chart 4: Size of Money Market Funds is a Barrier to Negative Rates

Source: Morgan Stanley

4.     Fed Funds Futures Pricing is not Solely Driven by Fed Policy, Hedging Plays a Role as well

The pricing of negative interest rates in the Fed Fund Futures market was driven to an extent by tail risk hedging – to protect oneself from a low probability event. Simply put, a floating rate receiver who wants to take protection against negative interest rates will enter into a floored swap i.e. will not need to pay if rates go below 0%. The bank will in turn hedge the risk by taking a long position in the Fed Fund Futures contract. This drives the price of the contracts up, and when volume of such hedges increase rapidly, the price will go above 100, and signal negative rates in the future. This is a case of “Self-Fulfilling Prophecy”. 

Conclusion

Just to recap, the effectiveness of NIRP is still up for debate, and the Fed believes it can achieve the desired results through its balance sheet and other liquidity tools. Negative interest rates will hinder the implementation of monetary policy and impact credit creation by banks adversely. NIRP will also potentially destabilize money markets in case MM funds experience negative returns. And last but not the least, passing an amendment for negative rates on deposits is definitely not a vote winning strategy – obviously not one for Donald Trump despite his fondness for the gift of negative rates.