Ever since the financial crisis of 2008, monetary policy has had an “Alice in Wonderland” feel. The whole thing has been a crazy experiment — and the experiment is still ongoing. The next bizarre chapter could be negative U.S. rates.
Negative interest rates have already shown up in bond markets all around the world. If negative rates come to America too — and if NIRP (negative interest rate policy) is implemented by the Federal Reserve — the central bank that manages the world’s reserve currency — the results could be wild.
Negative US rates would be potentially disastrous for certain areas of the market, like banks and brokerage firms. At the same time, they could be rocket fuel for other areas, like precious metals and Bitcoin, and a significant positive for debt-heavy industries like utilities and homebuilders.
So, what makes negative U.S. rates look like a real possibility, or even a likelihood? First, the markets are starting to predict this outcome. Second, the Federal Reserve itself is dropping hints. And third, the Fed may have nowhere else to go when the next real recession hits.
In terms of market predictions, the yield (interest rate) on long-term U.S. treasury bonds hit a record low last week. The U.S. government sold $16 billion worth of 30-year bonds at a rate of 2.17%.
The bond market is a barometer for expectations of inflation and economic growth. When rates are hitting record lows, that is a bad sign. And when they are hitting record lows at a time when the economy is supposed to be recovering, it’s a very, very bad sign.
The bond market, in other words, is all but flashing “SLOWDOWN AHEAD” in giant, glowing red letters.
Another area of the market is sending an even stronger signal. High-volume options trades in the eurodollar futures market are forecasting U.S. rates at zero or below.
Despite the name, eurodollar futures are not about euros or dollars. Instead, the eurodollar futures market is a hedging vehicle for U.S. interest rates. If a company outside the U.S. has interest rate risk tied to a dollar-denominated financing contract, for example, they can hedge that risk with eurodollar futures.
The eurodollar futures market is deep and liquid thanks to trillions of dollars in global trade flows. When eurodollar futures contracts are declining in price, that is a forecast for interest rates going up. When they are rising in price, it is a forecast for interest rates going down.
And right now, according to CME Group data, there are 1.2 million eurodollar futures options contracts forecasting zero or negative U.S. rates — meaning the options only pay out if U.S. rates go negative, at some point between now and 2022.
“People are trading things that imply negative rates are not just possible but reasonably probable,” the head of U.S. interest rate derivatives strategy at JP Morgan told the Wall Street Journal. “The market’s willingness to price in negative rates has gone up significantly.”
It makes sense too, because the Federal Reserve is dropping loud hints. On October 15th, the Federal Reserve Bank of San Francisco (FRBSF) published a paper titled “Yield Curve Responses to Introducing Negative Rates.”
You can read the paper here, but what really matters is the second half of the first sentence (italics emphasis ours):
“Given the low level of interest rates in many developed economies, negative interest rates could become an important policy tool for fighting future economic downturns.”
Hint hint, cough cough. If the Fed “goes negative,” they don’t want investors to be too surprised. So, they are sending up trial balloons in advance.
It is also reasonable to ask: If another recession hits, what other options would the Fed have?
Over the course of the past decade, the U.S. Federal Reserve already took the policy rate to zero and held it there for seven years. After a brief and tentative hiking period, they are now back to cutting again, with U.S. treasury bonds at the lowest yields in history. There is nowhere else to go.
If U.S. interest rates go negative, the fallout would be terrible for banks and brokerage firms, along with any other industry that earns a profit from positive interest rate spreads.
This is because, in normal times, banks turn a profit by “borrowing short and lending long.” They borrow money at very low short-term rates, lend out that money to customers at higher rates, and keep the difference as profit. The publicly traded brokerage firms do something similar. Charles Schwab, for example, earns more than half its revenue from the interest rate spread on idle cash in customer accounts.
But if U.S. rates go negative, that whole business model breaks down. You can’t make money on a positive interest rate spread if the spread itself disappears. The financial system is not designed for negative rates, a concept imported from the Twilight Zone. Under a negative U.S. rate regime, all kinds of financial plumbing could be ruptured.
At the same time, other areas of the market could do exceptionally well in a negative rates environment. Gold and Bitcoin, for example, would become even more attractive than they are now. While neither one has a yield, they would comparatively look great simply by not having a negative yield.
Other areas of the market, like utilities and home builders, could see also see a benefit from negative U.S. rates. The idea here is that, if rates go negative, industries that historically take on high levels of debt become better off. Utilities tend to hold a lot of debt: As their cost of financing falls, profit margins improve. And home builders use debt to fund new projects — if rates go negative, they also see an increased margin advantage.
No matter what, negative U.S. rates would have ugly consequences. William Eigen, a JP Morgan fund manager with 29 years of experience, thinks global NIRP is already a disaster in waiting, and a negative U.S. rate regime would make a bad situation far worse.
“What I’m saying is that you print this much money, you put trillions of dollars of securities on your balance sheet, at some point something’s going to break,” Eigen told Bloomberg. “I’m not saying it’s going to be in the short term, but man, when this thing breaks, the losses fixed-income investors will be facing will be devastating…”
Devastation or not, investors should prepare for the possibility of negative US rates — because the likelihood is rising with each passing day.
TradeSmith Research Team