Monetary Policy & Inflation | US
Several Fed Funds futures contracts began pricing above 100 last week, implying that markets were pricing in a small negative Fed Funds rate in the not so distant future. Here, we discuss why we expect Chair Powell to maintain a “constructive ambiguity” on negative rates in his speech on 13 May, and we explore the potential market drivers and implications.
The Fed did not use negative interest rates policy (NIRP) in its response to the global financial crisis for three primary reasons (Chart 1):
Fed economists were concerned that banks would withdraw deposits at the Fed (reserves) if rates fell below about -35 bps;
It is unclear if the Fed can legally implement a negative IOER, and the Treasury cannot issue debt at negative nominal interest rates (though it can issue TIPS with negative real rates);
The Fed is concerned that negative interest rates could trigger mass withdrawals from Money Market Funds.
Since leaving office, former chair Ben Bernanke has suggested that the Fed “should adopt a constructive ambiguity about negative short-term rates” to avoid also “creating an effective floor for long-term rates” because it could need them in future. Former chair Yellen and Powell have broadly stuck to the script, with Powell stating in September 2019 that “if we were to find ourselves at some future date again at the effective lower bound, I do not think negative rates will be at the top of our list.” Indeed, the Fed did not include negative interest rates in its 2019 review of policies and procedures.
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Several Fed Funds futures contracts began pricing above 100 last week, implying that markets were pricing in a small negative Fed Funds rate in the not so distant future. Here, we discuss why we expect Chair Powell to maintain a “constructive ambiguity” on negative rates in his speech on 13 May, and we explore the potential market drivers and implications.
The Fed did not use negative interest rates policy (NIRP) in its response to the global financial crisis for three primary reasons (Chart 1):
- Fed economists were concerned that banks would withdraw deposits at the Fed (reserves) if rates fell below about -35 bps;
- It is unclear if the Fed can legally implement a negative IOER, and the Treasury cannot issue debt at negative nominal interest rates (though it can issue TIPS with negative real rates);
- The Fed is concerned that negative interest rates could trigger mass withdrawals from Money Market Funds.
Since leaving office, former chair Ben Bernanke has suggested that the Fed “should adopt a constructive ambiguity about negative short-term rates” to avoid also “creating an effective floor for long-term rates” because it could need them in future. Former chair Yellen and Powell have broadly stuck to the script, with Powell stating in September 2019 that “if we were to find ourselves at some future date again at the effective lower bound, I do not think negative rates will be at the top of our list.” Indeed, the Fed did not include negative interest rates in its 2019 review of policies and procedures.
A September 2019 BIS review of unconventional policies supports the Fed constructive ambiguity on NIRP. The study concludes that NIRP was effective in lowering money market rates and bond yields but had a number of drawbacks including delaying balance sheet adjustments, reducing banks’ intermediation margins, and raising financial asset prices.
In addition, in December 2019 the Riksbank decided to end its five-year experiment with negative rates and go back to the zero lower bound, which is a good example of a central bank realizing that negative rates do more harm than good. And at the most recent Riksbank meeting, the governor reemphasized that they are not looking to cut rates but rather do more QE.
The coronavirus epidemic, however, has brought about an unprecedented economic collapse and renewed interest in negative rates. Ken Rogoff, former IMF chief economist, recently argued that the Fed policy of setting up a backstop for virtually every private, state and city credit is unsustainable if, as he thinks likely, it takes years for the US economy to recover. He believes that setting the Fed Funds rate at -3% or lower would be a more efficient policy because it would boost aggregate demand, raise employment, and “lift many firms, states and cities from default”. Rogoff, who favours the elimination of large denomination bank notes, believes the operational difficulties of deeply negative rates could be ironed out.
Despite Rogoff’s plea, we expect Powell to maintain the constructive ambiguity on 13 May for three reasons.
- The Fed still has substantial policy ammunition: the Cares Act allocated $450 bn to provide equity to Fed facilities that, if levered 10 times, would result in a $4.5 tn lending capacity. In addition, there is no set limit to Fed lending through the discount window, Repo or through the Primary Dealer Credit Facility or to ongoing Fed bond purchases of USTs and MBS (i.e. unlimited QE). Furthermore, the Fed can lean on forward guidance and has yet to implement yield curve control policy too.
- The Fed probably remains concerned that negative rates could destabilize money market funds. Indeed, it set up the Money Market Funds Liquidity Facility to finance purchases of MMF assets so as to maintain market function in that sector. In addition, any sort of changes to the money market industry should not come under the pressure of negative interest rate policy from the Fed. Leaving aside the idea that only Congress has the power to tax (effectively negative rates would be a tax on the financial system) and would likely challenge the Fed, we also believe NIRP would require inter-agency cooperation with the SEC and others, especially post the money market reform.
- We find it a bit ironic that Chair Powell announced his 13 May speech soon after Fed Funds Futures started pricing negative rates, which suggests he will want to clarify his views before the markets run away, and before a clarification of his policy plans results in significant market volatility. Interestingly enough, after the 13 May speech was added to the calendar, the Fed Funds futures market started to re-price back towards the zero bound versus going deeper into negative territory.
Market Implications
As seen in Chart 2, the front-end of the US rates market has been grinding lower ever since the Fed cut rates by a massive 100 bps down towards the zero-lower bound (ZLB) back in the middle of March. We must not forget that the rapid expansion of the Fed’s balance sheet has also exerted pressure on overnight rates and that is creating a push towards the ZLB in markets such as the repo market and T-bills at times. However the latest decline, as seen last week, was likely a combination of technical factors and negative rate fears feeding off each other.
Recall this is not the first time that the US rates market has flirted with the idea of NIRP in the US. Back in 2016, when the global economy was suffering from that period’s oil fallout and China revaluation aftershocks and, with other CBs already in NIRP, for a brief moment there was a series of options on US Eurodollar interest rate contracts being established to hedge for the off chance that the US would also fall into the world of negative interest rates.
It’s possible that risk-takers are back at it and expect that other financial institutions will need to hedge just in case the Fed does NIRP and are getting ahead of themselves. Similarly, such financial institutions are realizing that the Fed will be keeping rates near zero for the foreseeable future and that will drag down all lending rates and thus could also be executing NIRP hedges as their book of business may see yields go razor thin.
We do not expect Chair Powell to list NIRP as the Fed’s next obvious tool of choice. Instead, we anticipate that he will emphasize that they have many other tools that could still be maximized before they ever need to contemplate going down the NIRP path. In the end, there isn’t much of a big trade to do on this because all the Fed probably wants is to maintain market function in the Treasury market while keep front-end rates range-bound and less volatile.
Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.
George is a twenty years fixed income markets veteran. Over that time he has covered rates, structured products and credit. He worked both on the buy-side and sell-side.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)