Macro Research

Are negative interest rates coming for the US? Here's what investors should know about it.

With interest rates kissing the zero-bound and market participants briefly pricing in negative fed funds rate in early 2021, the possibility of negative rates reaching the US financial shores is building. In this article, we discussed the possibility of NIRP, its investment implications, the outlook for interest rates and how to position for it.

iFAST Macro Research Team
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Published on 24 May 2020

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We think Europe and Japan are good examples that despite NIRP, long term growth and inflation were not achieved. These drawbacks were (i) rapid outflow of deposits., (ii) erosion of interest income of banks and (iii) dependency on cheap debt.

Three factors shape our belief that NIRP will see high hurdle of implementation - (i) Negative impact outweighs the positive, (ii) Fed is not yet out of ammo and (iii) inconclusive effectiveness of NIRP to stimulate inflation and growth.

Yields in the US are likely to go even lower and for a longer period. We see zero hikes from the Fed over the next one year. Interest rates for other DMs and many EMs will likely see the same.

In the aforementioned backdrop, we remain in favor of IG corporate debt, particularly US IG debt. Within the high yield (HY) space, we think some EMs may see further downgrades to growth as well as earnings. Investors can position more aggressively when fundamentals show signs of improving. We prefer US and Asia HY debt over EM debt.

The US Federal Reserve (Fed) has lowered interest rates to near zero this year – reducing by 1.75% within the first quarter of 2020 – as part of its monetary toolkit to stimulate an economy that is rapidly falling apart with the global Covid-19 pandemic.

Despite the slew of accommodative measures rendered thus far, the US economy remains mired in a recession this year. If the US were to slide further into a prolonged and deep recession, it is reasonable to expect that the Fed would deploy greater and more extreme stimulus measures ahead.

However, with interest rates nearing zero, surely the only way to ease further would be go negative?

In fact, market participants have already briefly pricing in negative fed funds rate (early 2021 on 7 May).

In this article, we will explain more about negative interest rates, discuss why we doubt that it will be deployed in the US, as well as some of implications it will have on global capital markets in the event Fed adopts such a controversial policy.

Chart 1: Markets priced in negative rates in early May for Dec 2020 and Jan 2021 contracts

What is negative interest rate policy and why the sudden interest in it?

While the Fed has repeatedly rejected the idea of negative US interest rates, the market has recently priced in such a possibility. President Trump has also been quite vocal about his support for a Negative Interest Rate Policy (NIRP).

To start, Interest rates has always been the main policy tool of central banks around the world. Its relative simplicity and effectiveness in managing inflation and spurring economic growth has made it a go-to solution for policymakers. By lowering rates, cost of borrowing become cheaper, which is beneficial in encouraging consumer and business spending. Companies boost investment, taking advantage of cheap borrowing to make large equipment purchases, which improve their long-term growth potential.

Hence, when interest rates are close to zero, NIRP seems like a natural extension of accommodative monetary policy. The negative interest rates are typically applied to the excess reserves which banks and other financial institutions (FIs) hold with the central banks. As a result, FI like Citibank must start paying the central banks for storing the excess reserves beyond the minimum requirement. The theory is to force FI to lend more and invest in more productive assets, thereby further stimulating economic activities.

While a novel concept, the NIRP is also a highly controversial one – economists around the world remain divided on it till today. But it has not stopped policymakers from experimenting with it. In fact, other global central banks in Europe and Japan have deployed it for years. What is troubling though is that their results so far have been mixed at best.

Things can get more complex when the interest rates enter negative territory in the real world,

Why did Europe and Japan pursue NIRP in the first place?

Two notable economic powers which have turned to NIRP are the European Union (EU) and Japan. Prior to implementing NIRP, these developed economies (DM) were plagued with chronically low inflation and economic growth.

For Europe, the EU region was hard hit by the 2008 Global Financial Crisis. The European nations were also struggling to recover from their sovereign debt crises. High unemployment and weakening domestic demand caused a deflationary spiral, with wages, consumption and prices falling in lockstep. The fiscal austerity imposed on several EU member states – Greece, Portugal, Ireland, Spain and Cyprus – meant little room for fiscal stimulus.

For Japan, the real estate and stock market bubbles in 1990s have brought Japan into a steep recession – one where Japan struggled to recover from. Since then, the Bank of Japan has cut interest rates and implemented multiple stimulus packages. Despite its efforts, Japan has had almost no economic growth for 25 straight years. In 2016, the appreciation of the Japanese Yen drew fear that this would increase prices of exports and thus reduce demand for Japanese exports, which would hurt Japan’s export reliant economy.

The EU bloc first pushed interest rates below zero in June 2014, aiming to halt the deflationary spiral. In theory, this will discourage lenders from parking excess reserves with the ECB, and instead lend it out to businesses and consumers. Policymakers were hoping that it can also encourage greater investment and spending in the economy, pushing prices back up and reversing the deflationary spiral.

Japan was next to follow. Similar to EU, Japan was hoping to use NIRP to discourage saving and boost spending. In addition, Japan’s NIRP would make the Yen a less attractive investment and cause it to depreciate, which drives up import costs, incentivising locals to domestic products and drive up inflation, tackling Japan’s persistently low inflation rate.

What are the potential pitfalls of NIRP?

Yet, not only did years of NIRP not alleviate the situation, it could led to a plethora of other complications within these DMs. Things get more complex when interest rates approach the negative territory in the real world.

Firstly, if commercial banks decide to pass negative interest rates on to clients, charging them a storage fee for holding their cash, this could spark a rapid outflow of deposits. Depositors rush to withdraw their savings and hoard cash to avoid being charged a fee for storing their money in banks.

This has the adverse effect of reducing the amount of liquidity in the banking system, effectively pushing interest rates (which represent the cost of borrowing) back up.

Secondly, the negative rates will erode interest income of banks (typically the stable portion of their profit generation), causing banks to scale back their lending activities further, in a bid to reduce risky loans and avoid costly defaults.

Thirdly, long-term NIRP also presents a whole of new problem in itself, where economic activity becomes dependent on cheap debt. Once the idea of cheap debt become too entrenched, policymakers will grow incrementally more reluctant to risk the plausible blowbacks of unwinding the negative interest rates.

Longer periods of negative interest rates mean companies take on more leverage, causing the financial system to be less resilient and more prone to macroeconomic shocks, harking back to the Global Financial Crisis of 2008-2009. Moreover, negative interest rates hurt retirement plans and pension funds. The returns on these savings vehicles are highly correlated with government bond yields, which were depressed by the NIRP. As such, the economic prosperity of working-class retirees tends to be affected by prolonged NIRP.

Chart 2: Japan’s GDP and consumption remained tepid even after NIRP…

Chart 3: … same for Europe

Likelihood of negative rates in US

Aside from the Fed rejecting the idea of NIRP on various occasions, we base our belief on three factors, i) negative impact from NIRP outweighs the positive, ii) Fed is not yet out of ammo and additional monetary measures will have to fail, and iii) inconclusive effectiveness of NIRP to stimulate inflation and growth. Taken together we see a high hurdle for NIRP to materialise in the near term.

NIRP will have a far-reaching impact on the US financial market, which is not designed for such unconventional policy. The primary blow will be felt by the US financial market, especially the banking landscape, which will inevitably be rocked as profitability withers. European/ Japanese banks are prime examples where earnings did not recover to their former glory and prices have been punished by markets.

We think the Fed is not out of ammo yet (also mentioned by Fed Chairman Powell). A key function of NIRP is to make liquidity plentiful and the Fed can achieve that without resorting to such unconventional policies. Also, for NIRP to be adopted, we believe further (larger) rounds of asset purchases will have to demonstrate a lack of effectiveness.

Last but certainly not least, while NIRP has proven to function in Europe and Japan, its effectiveness to stimulate inflation and growth is undoubtedly in question. Applying NIRP to US will definitely be more challenging and may even be less effective on the US financial system.

Chart 4: European and Japanese banks have been punished for negative rates…

Chart 5: … Valuation also fell to all time low

Investing in a negative rates environment

If the yield curve sinks into negative territory, investors have to rethink the composition of their capital preservation exposures and coupon income. Allocation to riskier assets (than treasuries) such as investment grade bonds may be considered, given their higher yields and more pristine credit ratings. Negative yields does not mean investors have to take on excess risk by overreaching for yield.

On the other hand, negative yields will undoubtedly engender a fierce hunt for higher yielding assets. Lower-rated debt such as high-yield debt may benefit. However, doing so investors should not forget a key objective of fixed income allocation, which is earning steady coupon income and to balance the risk-return in their portfolio.

While negative yielding bonds may not be attractive if held to maturity, prices may still rise over intermittent periods should yield fall further, demonstrated by German treasury bonds. In the same vein, for investors with existing exposure to treasuries, a decline in yields would translate to price return for investors. Just because yields are heading to negative does not mean investors need to cut exposure to them as they may have value in a diversified portfolio.

Chart 6: Amount of negative-yielding debt has accelerated over the last 1.5 years

Outlook for interest rates amid the Covid Crisis

Looking ahead, yields in the short term of the curve, for the US, has room to go even lower and will remain so for a longer period. The Fed has indicated they will keep policy rates at 0% for “as long as it takes”. We see zero hikes from the Fed over the next one year as the economy should be in repair mode while inflation expectations will be overwhelmed by the disinflation narrative.

On the intermediate term of the curve (not more than 10 year maturities), rates will be kept low for a combination of reasons. Firstly, the low inflation expectation over the next one year or so will keep rates down. Secondly, we expect US policymakers to suppress long-term rates to minimize borrowing/ refinancing costs for both public and private sectors.

With such an atomic issuance in government bonds and mounting refinancing stress, we think the Fed will prioritise to keep rates low in a bid to defend against a solvency crisis. The result could be progress towards a tamer version of yield curve control.

In the same vein, near-term interest rates for other DMs and many EMs will also be lower for longer. Some EMs (i.e. Brazil and Indonesia) have slashed rates tremendously while others (i.e. Chile, S. Korea) have rates close to zero. We do not see near-term rates rising for EMs and other DMs on the back of poor growth and inflation prospects.

How should investors position?

Our views on fixed income segments moving forward are shaped by the interest rate outlook (discussed above) and the macroeconomic backdrop.

While 1Q gave us a taste of the economic pain, 2Q is likely to be far worse. 2H 20 will remain challenging as we see major uncertainties such as (i) the possibility of a second wave (ensuing lockdown again?), (ii) how will consumer and businesses resume (operating at what capacity) and (iii) will policymakers manage to prevent a solvency crisis. While a vaccine can be a game changer, we think these uncertainties will determine the length of the recession and economic recovery.

In view of a tumultuous macro backdrop, we remain in favor of investment grade (IG) corporate bonds. Liquidity has improved but our main concern is still a solvency crisis. We believe issuers in the IG segment are less at risk due to the better cashflow and balance sheet.

The Fed’s corporate bond buying programs are a major support, particularly as a backstop for stability as well as liquidity. US IG is also more attractive from a capital gains and yields perspective, relative to the safer treasuries.

Within the high yield (HY) space, certain regions (i.e. EMs) may see further downgrades to growth and earnings, which may widen spreads and lower quality issuers may suffer further downgrades/ defaults. Therefore, the risks are highly contingent on the macro outlook. Nonetheless, we think yields are still appealing, especially in a lower for longer yield environment.

From a regional perspective, we prefer US and Asian high yield given a better risk-reward profile (against EM debt). Investors can gradually position more when macro fundamentals and earnings start showing nascent signs of recovery. Even without negative rates, there will soon be a frantic search for higher yielding assets, driving appetite towards HY bonds.

Chart 7: Yields for US IG relatively attractive in the higher rated credit space

Chart 8: Spreads have declined and are holding steady as insolvency uncertainty permeates

Chart 9: Insolvency may pick up not just in the US but elsewhere too

The Research Team is part of iFAST Financial Pte Ltd.

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