Are negative interest rates coming to the U.S.?


Are Negative Interest Rates Coming to the U.S.?


By Michael J. Bazdarich, Product Specialist at Western Asset Management


With negative interest rates becoming common in Japan and Europe, it’s worth considering whether they could reach the U.S. during the next recession. How would the U.S. Federal Reserve, Congress and private banks implement negative rates? What unintended consequences could we see? Finally – and perhaps most critically – how could U.S. investors circumvent negative rates?

The Fed’s Role

The U.S. Federal Reserve sets great stock in its ability to aid the national economy during recessions. During each recession since the 1970s, it has cut short-term interest rates by more than 500 basis points.

Prior to the coronavirus-induced rate cut on March 3, the fed funds rate had stood 1.55%. Therefore, short-term rates are likely to stand below 2% when the next recession emerges. If the Fed pursues rate cuts similar to those of previous recessions, a move to the negative is inevitable.

Below-zero interest rates on monetary policy variables are known as negative interest rate policy (NIRP). The European Currency Union has been practicing NIRP since 2014; it has been in effect in Japan since 2016. In fact, the yields on sovereign bonds are negative throughout the developed market world except in the U.S., the U.K. and Norway.

Bond Math

Can bonds be priced in a negative-yield environment? Yes, the math works just as well with negative yields as with positive yields. See the full content of this paper for the details.

Bonds in Europe and Japan do not have negative coupons. Rather, they have positive or zero coupons, but their prices have risen so high that their yields are now negative.

We think the U.S. financial markets will have no technical difficulty dealing with a negative rate environment. We can look to continental Europe and Japan to help inform our view of how consumers, private banks, the U.S. government and the capital markets are likely to react when confronted with negative rates.

Commercial Banks

Banks are required to hold some of their assets as reserves by central bank regulation and as part of sound operating principles. Under NIRP, the European Central Bank (ECB) and the Bank of Japan (BoJ) have shifted from paying positive interest on reserves to “charging” a negative rate of interest on them.

Banks could avoid these charges by holding cash in their vaults on which they would earn a zero yield. But reserves are much more liquid when held on deposit at the central bank than when they are stashed in bank vaults. That is why European and Japanese banks are now paying a fee for the “privilege” of holding reserves on deposit at their respective central banks.

Individual Investors

Until this century, students of central banking believed rates could not go below zero. The presumption was that people would never accept negative rates because they could always get zero by holding cash.

Banks in Europe have kept explicit deposit rates at zero for most retail customers and covered their costs by increasing flat fees for opening and maintaining accounts. Consumers have not had to pay explicitly negative rates so there has been no price incentive for them to reduce their deposits unless they are willing to forego their banking relationships altogether.

European banks have been able to get by on fee increases alone because the ECB’s policy rates have been only somewhat below zero. However, with the latest cuts in the summer of 2019, EU policy rates have become sufficiently negative that commercial banks are starting to impose explicitly negative rates even on retail deposits.

For roughly the past four years, European and Japanese investors have been able to access U.S. dollar-denominated instruments with positive returns, which has eased their pain. But if the U.S. goes negative as well, there could be an exodus into cash.

Conclusion

The financial markets will have no technical difficulty dealing with a negative-rate environment. The difficulties in implementing and sustaining NIRP in the U.S. will come from getting the private sector to refrain from circumventing negative rates via increased holdings of cash. Moreover, the country will have to confront the problems insurers and pension funds will face if they are to survive a negative rate environment.

For more information, see this newly published paper.

Michael J. Bazdarich, PhD, is a product specialist/economist at Western Asset, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.

Michael J. Bazdarich

Product Specialist at Western Asset Management


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