Once unheard of, negative interest rates emerge as a viable Fed tool

With Federal Reserve Chair Janet Yellen confirming before Congress this week that a negative-interest-rate monetary policy is a plausible option, financial advisers might already be weighing the investment alternatives in such an unprecedented environment.

For some context, consider that as recently as 18 months ago, virtually every economist in the history of economics has argued the impossibility of negative real rates, yet there are now five countries using negative rates as a monetary tool.

“I don’t know what’s more bizarre: negative interest rates or the fact that they’re becoming an accepted form of monetary policy,” said Bob Rice, chief investment strategist at Tangent Capital.

“It’s so mind-blowing, it’s like ‘Alice in Wonderland,’” he added. “If rates are going to be negative, why not just put your money under your mattress instead of losing it in a bank?”
The Fed, which hiked rates off the zero mark to 25 basis points in December, is still a long way from dipping into negative territory. Any move in that direction would likely first involve a rate cut back to zero, which doesn’t yet appear to be on the table.

But with the Bank of Japan’s recent move into negative-rate territory, joining four European economies already applying negative rates, there is growing speculation that the Federal Reserve might eventually join the party.

The fact that the options market for the London Interbank Offered Rate is already signaling a 20% chance the Fed will introduce negative rates by 2017 is a pretty big deal, especially when you consider that just a few months ago the Fed was still talking about four interest rate hikes in 2016.

“I think we’re backsliding from even a few months ago when the economy looked like it was doing better,” said Doug Cote, chief investment strategist at Voya Financial.
“The central banks are walking a tightrope of trying to stimulate the economy and not hurting the banking system with negative rates, because negative rates are very contradictory for the banking system.”

The contradictory part doesn’t even include adjusting to the notion of having savers pay interest to have their money held in a bank, according to Mr. Cote.

“It is becoming an accepted practice and I think Yellen is arguing for banks to put it into their scenario for the next stress tests,” he added. “It’s one of the reasons banks are selling off, because of the concerns about the spread between the long rates and what they borrow at.”

For investors and savers, especially those in or near retirement, the idea of negative interest rates is less complex.

“I suppose it means you could just put your cash under the couch, but you’d also want to invest in long-duration Treasuries because the price would go up as the yield goes down,” said Crit Thomas, senior investment strategist at Touchstone Investments.

“When I look at what’s already going on in Japan and Europe, it has a real experimental feel to it, and I think we’re fighting a confidence battle,” he added. “I’m fearful of the unintended consequences that are not apparent now, but will be apparent five years from now.”

As with the zero-rate policy that the Fed instituted during the 2008 financial crisis, followed by three rounds of quantitative easing, negative interest rates are supposed to move money toward riskier assets like stocks, and also fuel some inflation.

Negative rates would also likely help weaken the U.S. dollar, which would make U.S. exporters more competitive. That factor alone is driving some speculation on how much the negative-rate migration could expand.

“The main reason Japan went negative is to weaken the yen,” Mr. Rice of Tangent Capital said. “This could effectively become a currency war, through the use of negative interest rates.”

Psychologically, a move to negative interest rates is still viewed as far too extreme for the U.S. economy to absorb.

“It would be pretty scary, because the backdrop would have to be pretty negative,” said Mr. Thomas. “You’re talking about recessionary type economic conditions.”

If the Fed ultimately moved in the direction of negative rates, it would primarily be trying to force banks to start lending out some of the $2.4 trillion worth of excess reserves that they currently have on deposit with the Federal Reserve, yielding between 25 and 50 basis points.

“Negative rates will kill savers and retirees, but that’s not what the Fed is focused on,” said Mr. Cote of Voya Financial. “They’re trying to spur lending by penalizing banks for holding reserves.”

There is growing debate over whether the Fed even has the authority to set rates in negative territory, but as a tool for sparking inflation and fueling economic growth, negative rates are as untested as the Fed’s $5 trillion-dollar quantitative-easing experiment.

“Right now the Swedish central bank is trying to push yields down to an even more negative level, so that should tell you something about how well negative yields work,” said Quincy Krosby, market strategist at Prudential Financial.

A big risk factor with negative rates is that it could be interpreted as a desperate last-ditch effort, which could make the market even more cautious.

“The goal of negative rates is to get banks to stop sitting on so much cash, because you want them to create demand and, in essence, try and create inflation,” Ms. Krosby said. “But it will be seen as a signal that the Fed is out of tools, and that the deflationary forces are getting stronger. If there’s no demand, and no sense that the economy is growing, you could make money as cheap as possible and it won’t matter.”

That is essentially the tug-o-war between inflation and deflation that the Fed is trying to manage.

“I have thought a fair amount about this, and the government has a desire to keep rates low,” said Hugh Lamle, president of M.D. Sass.

“They may have to introduce negative interest rates, but that will make U.S.-dollar-denominated fixed income less attractive to foreign investors,” he added. “Low rates benefit borrowers, but they don’t benefit a lot of other folks, and it’s very negative for retirees and anybody about to retire.”

Related Topics: Federal Reserve, Interest Rates