Until now, the US has avoided the negative rate phenomenon that has become embedded in the monetary and fiscal environment of Europe and Japan. To recycle and parody parts of a phrase that former Fed Chairman Ben Bernanke used almost twenty years ago reflecting on deflation in Japan – “It (Negative Rates) will likely happen here too”.
The US Fed has resisted cutting rates below zero so far. In my opinion, it is only a matter of time before either current Fed Chairman Jerome Powell or the one to follow him announces negative interest rates in the US, not because they want to, but because they are forced to. And yes, it will be another pivot or piroutte, and “data-dependence” and a new understanding of the way the economy and the markets work will be used as the justification for the change in philosophy.
The massive amount of money that is being globally thrown at the economy and the markets will result in this negative rate outcome as the path of least resistance and an unintended consequence of too much liquidity in all the right — and all the wrong — places.
First, the Treasury Bill market is already trading at negative yields. As of March 26, 2020, the one month T-Bills were trading at a (negative) yield of approximately minus fifteen basis points (Source: Bloomberg). This is the market “clearing” rate where demand meets supply. As of this writing, an investor could have bought bills in the Treasury auction at 0% yield, and sell them to a buyer in the open market at a negative yield, pocketing a tidy, almost risk-free profit. Since yields move inversely to prices, this means the investor is buying from the Treasury in the auction at a lower price and selling it in the open market at a higher price, transferring wealth instantaneously from the taxpayer to take advantage of this arbitrage.
The Treasury Secretary works for the President, and the President has repeatedly called for negative interest rates, so I do not see any reason why he would not insist that US Treasury auctions allow for investors to pay a fair market, higher price to the taxpayer who is ultimately lending the money to the investors. But if T-Bills are auctioned at a negative rate in the future, the Central Bank will need to take a cue from the market and go negative to keep the short end of the yield curve from becoming more distorted than it would otherwise be. This is basically what happened in Europe and Japan, and I suspect it will happen in the US.
Second, Fed Chair Powell, in his most recent television appearance (NBC news Today show March 26, 2020) left the door slightly open for other measures when and as needed. Given that the Fed has already cut rates by 150 basis points in the last month, to almost zero, by definition there is not much ammunition left in the rate bazooka unless they cut below zero. This ammunition also consists of QE infinity, which is a stealth way of generating so much liquidity that investors are willing to lend at negative rates. The outcome is the same: either explicitly cut rates below zero, or make the market rates go below zero first. Our analysis shows that in the last month that due to the stock market crash financial conditions have tightened as if rates were raised 1.5% to 3%. To undo this sharp tightening that happened due to the fall in equities and widening credit spreads, the “shadow” interest rate has to fall way below zero. In other words, the observed, true interest rate is too high by the same magnitude.
The Fed, according to Powell, wants to see credit flow, but it is “limited by our ability to take losses” (Powell, 3/26/2020) on the collateral that the Fed buys. Currently they are buying only investment grade bonds and ETFs. But the need for credit in all the right places, i.e. small companies and individuals is much bigger than the investment grade bond market. For starters, a further unraveling of the equity markets, which could filter adversely into the high yield market, will force the Fed to try to support the lower rated, riskier sectors of the economy indirectly. Since they are limited by the ability to take credit losses, the only way to “make credit flow in the economy” is to make saving costly for private investors, i.e. by driving private investors to take the risk of losses and investing in these riskier assets.
Third, if the recent European experience is a model of things to come, keeping short rates at zero and not going below will drive yield seekers to longer duration bonds. This will flatten the yield curve. The combination of low short term rates and lower long term yields is sand in the gears of the banking system which relies on borrowing short and lending long. While there is no simple solution other than helicopter money given to the banks, steepening the yield curve and hoping that banks can make the “carry” from lending long and borrowing short might help the banks for a little while. Of course, if banks are required to keep money at the Central Bank and pay interest, as they have to do in Europe, this would be a significant negative for the banking sector, especially if they go deeper into toxic lending. A steep yield curve is good for bank profits, so how do you steepen a yield curve when short rates are already at zero? By going negative, of course!
Fourth, as the ECB and BOJ and rest of the world keeps going deeper into negative territory, the US keeping rates above zero, all else being equal, strengthens the dollar. A strong dollar in an environment of de-risking and rising global defaults can only create more shortages of the currency and possibly even tighter global financial conditions. Taking rates below zero will perhaps dissuade dollar hoarding, or at least slow capital flows into the US bond markets.
Fifth, and perhaps here I am treading on thin ice, negative rates are the simplest way to transfer wealth from savers to borrowers, or from the rich to the not so well off. When the burden of trillions of debt is high, the overall economic system probably only survives via this mechanism of stealth socialism. For the collective welfare of all the citizens of an indebted nation, taking money from the haves and giving it to the have-nots in theory reduces the wealth distribution in the short run. I suspect that this government led bailout of the private sector will pay its dues by penalizing savers, who are typically those with surplus assets and who have benefited incredibly from the bull market in assets.
If the Fed can go negative, as I think it will have to, what should an investor do?
First, if interest rates are likely to go negative, then it makes eminent sense to buy short term to intermediate term bonds when yields are still positive. For example, even though a two year Treasury note today looks awfully pricy with only 0.30% of yield, if rates go negative that yield with almost no principal risk looks quite juicy! On the other hand, negative interest rates are like throwing gasoline on a smoldering inflation fire which could become an inferno in a flash. Once started, inflationary expectations can swiftly calibrate higher and affect investors’ behavior rapidly. Holding longer term, low-yielding Treasuries in an inflationary environment is not the best decision to protect principal.
Second, negative interest rates by their nature create winners and losers across industries. Sectors with high costs of debt servicing, rate sensitivity and embedded leverage (startups with good ideas, small-caps, exploration, resources) will obviously benefit, whereas sectors that make money from interest income (banks) get hurt.
Third, negative interest rates in the US have the potential of turning the tide in favor of foreign assets which offer higher yield. In such an environment the dollar weakens, and emerging market assets, especially emerging markets bonds and currencies begin to regain some of the ground they have lost over the last decade. In other words the US dollar becomes the funding currency for carry trades around the world.
Finally, the need for yield in a negative interest rate world restarts the short-volatility, “shadow financial insurance” business all over again, after its most recent, and much anticipated blowup. Survivors from the wreckage of volatility sellers can make profits while rates stay low.
And of course, this re-starts the boom part of the next cycle from the bust of the last cycle. Despite claims from ivory tower economists that the business, credit and financial cycle has (yet again) been conquered, negative interest rates will enable the next asset market bubble to rise from the ashes of the prior one. Grounded investors will do well systematically buying insurance for when, inevitably, the larger and larger bubbles of liquidity fueled euphoria implode and create fleeting but incredible value.
I used to cringe when my wife asked: “How did the economy do today?”; My response: “you mean how did the stock market do today?”, because in my mind and the mind of most investors the market fluctuates, but the economy does not really change from day to day.
But I think she, as usual, was right after all: in the final analysis, in a levered, financialized economy, the stock market IS the economy, and the economy IS the stock market. And to revive the stock market, er, the economy, the Fed will have to go negative in one form or another.