While Negative US Interest Rates Are Possible, Odds of Reality Look Less Than Zero

August 12, 2019 by Jon C. Ogg

Many articles have pondered the short-term and long-term impacts of negative interest rates around the globe. Some of these concerns are recent, while some have persisted for years. One recent tally even put the amount of sovereign and related bond issuances trading with negative yields at close to $15 trillion. These are mostly in Europe and in Japan, but what about the real possibilities of negative interest rates in the United States?

Note and bond buyers who purchase central bank maturities with an interest rate under zero percent, hence negative yields, are effectively being forced into losing money every year until maturity. With many articles now pondering if negative interest rates are likely coming to the United States, there are many questions to answer about who really pays for those negative interest rates.

There are many market forces at work simultaneously, along with central bank debt purchases, for negative interest rates to prevail. Ultimately it is the investing class that “pays” in the end for negative interest rates. That said, the notion of who really pays for negative interest probably should considered a scenario in which there appear to be forced losses rather than actual fees charged to bond investors. This could be viewed as a loss, fee, tax or even reverse loan.

For a central bank to have negative interest rates, something is far from peachy in the economy and in the financial markets. To ponder negative interest rates in the United States in 2019, that is another situation in which the financial media’s headline writers have gone above and beyond reality versus actual market and economic conditions. The United States is in a self-imposed war with China, and the aim is to undo much more than trade deficits. The global growth story also has continued to slow, but neither the United States nor the global economy are actually in a recession.

Multiple freshly issued economic warnings need to be addressed in a longer-term outlook. UBS now sees three interest rate cuts coming by the U.S. Federal Reserve, and maybe even more. Morgan Stanley has issued a warning that the Federal Reserve could return to a near-zero interest policy, similar to what was seen from all of 2009 through 2015. Merrill Lynch also has warned of increasing chances that the economy will tip into a recession over the coming 12 months. And Goldman Sachs has lowered its fourth-quarter GDP forecast to growth of 1.8% from its prior 2.0% forecast.

These are not pretty, but they are far away from a recession, and they are not forcing actual market expectations into believing that negative interest rates are coming to the United States any time soon. A note from CNBC also warned against the (above) panic of negative interest rates in the United States:

  • However, none of the current forecasts are for negative yields. The closest the Fed has ever come to entertaining the idea was three years ago when it instructed banks to prepare for a negative-yield scenario in their mandated stress tests.

As for negative interest rates from the actual market and federal funds futures, the CME FedWatch Tool from August 12, 2019, should offer a more reasonable outlook. The current range of fed funds is 2.00% to 2.25%, down from the peak of 2.25% to 2.50% prior to last month’s rate cut. The current CME FedWatch Tool has a 0% chance that rates will not be cut at the September 18, 2019, FOMC meeting. It is forecasting a 78.8% chance that fed funds will be cut to a range of 1.75% to 2.00%, and a 21.2% chance that the range will be lowered to 1.50% to 1.75%.

Now, zoom all the way out to the April 29, 2020, FOMC meeting predictions. Whatever the rate will be, current projections are calling for the funds rate to be lower. The CME FedWatch Tool shows the following probabilities of where fed funds will be at that time:

  • 25–50, 0.2%
  • 50–75, 2.5%
  • 75–100, 12.3%
  • 100–125, 29.3%
  • 125–150, 34.2%
  • 150–175, 18.2%
  • 175–200, 3.3%
  • 200–225, 0.0%

The 30-day fed funds futures prices also offer some added insight into where interest rates will be in the months and even the years ahead. Out to January of 2021, the fed funds futures prices on August 12 were indicating that fed funds would not likely be under 1.00%. The effective range of 1.00% to 1.25% looks likely to be the case from June of 2020 through December of 2020. That can of course change, and it could change rapidly if conditions get worse than currently expected.

While negative interest rates indicate a forced loss on the surface, that’s the implication if there is not “even worse negative rates” ahead. If a central bank’s notes are longer-dated, and the (theoretical) current yield is −0.30%, there is nothing that would prevent a central bank’s policies for short-term rates the financial markets’ price mechanism from forcing that rate down to −1.0% or even lower ahead. Instead of buying and holding to maturity, a bond/note holder could sell the bond at a premium (or profit) to the price paid to new buyers down the road. It’s the “theory of the greater fool” on steroids.

There are also some theoretical issues around how this would play out in taxes in the United States. It’s one thing to have capital gains turn into capital losses in investing, but imagine the investing public reporting billions or trillions of dollars in negative interest rate coupon payments on their taxes. This is simply unknown territory in the United States.

Imagine if nonsovereign debt were to come with negative interest rates. Where things get really complicated in a scenario of negative interest rates would be around when corporations, banks, municipalities and even mortgages would trade with negative interest rates. Would people dare pay money to a corporation just for the privilege of getting less money back in the future? Would mortgages actually be paying a borrower to take out a mortgage and live in a home? In Europe, during the prior period of quantitative easing, there have been some isolated incidents there and in Japan where those scenarios were real.

In the wake of the Great Recession, the Federal Reserve maintained a policy of zero interest rates (ZIRP) but it did not embark on a policy of negative interest rates (NIRP). That said, there were some inflation protection Treasury issued TIPS that did price with negative interest rates during the recovery.

The goal of negative interest rates is to put economic stimulus on steroids. If a lender or a corporation believes it will be forced into a loss on holding cash, then they will be incentivized to put that money to work via loans, capital spending or other means of spending to incentivize income. There is no simple answer when it comes to who really pays under negative interest rates, but on the surface it seems everyone really pays when there are such rates.

A Federal Reserve white paper from 2016 predicted how U.S. banks would fare under a period of negative interest rates. The conclusion, some 25 pages in, suggests that one-third of banks would expect their earnings to be negatively affected and one-third would expect bank earnings to be positively affected. In 2015, one FOMC member did at least suggest that banks might need to prepare for negative rates. A fresh view from PIMCO also shows how banks would be paying for excess reserves.

This debate over negative interest rates is a debate that simply has no end. And the answer in determining who ultimately pays the price for negative rates — well, that just depends on the circumstances. Regardless of the debate, negative rates sound very supportive of gold and companies that are believed to have safe and solid dividends regardless of each business cycle.

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