Questions have surfaced recently about the possibility of negative rates in the US. Similar questions arose back in March when the Federal Reserve (Fed) quickly cut interest rates from its target range of 1.50%-1.75% to 0.00%-0.25%. At the time, markets reacted strongly. Treasury bill (T-bill) yields fell into negative territory as investors flocked to the safety of short-term Treasuries but were met with insufficient supply. Since then, the Treasury and Fed have acted to help eliminate this supply/demand mismatch:
- The Treasury increased T-bill issuance. T-bills outstanding rose by $1.4 trillion in March and April (Figure 1).
- The Fed shifted purchases of Treasury securities to include other maturities besides T-bills.
Figure 1: Volume of Treasury bills outstanding
These measures had their intended effect, and T-bills now trade at positive yields across the maturity spectrum. So why the renewed focus on negative interest rates? Recent attention has been driven by the federal funds futures market. In early May, federal funds futures price levels implied a negative federal funds rate as early as December 2020. This was the first time that federal funds futures contracts traded above $100 (implying a negative federal funds rate).
We continue to believe that the likelihood of the Fed instituting a negative interest rate policy (NIRP) is very low in the near term. Fed chairman Jerome Powell has been clear in his messaging, stating in March that, “We do not see negative policy rates as likely to be an appropriate policy response.” In a May 13 speech, he confirmed that, “The committee’s view on negative rates really has not changed. This is not something that we’re looking at.”
Below we outline our views on the possibility of negative rates emerging as a potential monetary policy tool, in the short-term Treasury markets and in money market funds.
Negative rates unlikely as a Fed policy tool
Fed messaging and potential legal and technical hurdles make NIRP unlikely in the near-term. In a May 60 Minutes interview, Chairman Powell stated, “I continue to think, and my colleagues on the Federal Open Market Committee continue to think that negative interest rates is probably not an appropriate or useful policy for us here in the United States.” He added, “…there’s no clear finding that it actually does support economic activity on net. And it introduces distortions into the financial system, which I think offset that.” He concluded by saying, “There’re plenty of people who think negative interest rates are a good policy. But we don’t really think so at the Federal Reserve.”
Fed staff have also pointed out that negative interest rates could raise legal and technical issues, especially when it comes to imposing a negative interest rate on the excess reserves that banks hold with the Fed. We believe Congress would need to change existing laws before the Fed could actually “charge” banks a negative interest rate on their excess reserves.
Negative yielding short-term securities unlikely to become the norm
The Fed and Treasury have various tools to support short-term Treasury yields above zero. Negative-yielding Treasury securities are not unprecedented. They have occurred briefly at key month-end and quarter-end dates but have not been pervasive in US markets.
More recently though, during March’s financial turmoil, Treasury securities were offered at negative yields across much of the short-term maturity spectrum. As a result, the Fed and Treasury actively intervened, preventing negative rates from persisting at the short end of the yield curve.
The Fed and Treasury have several tools at their disposal, such as reducing the amount of Fed purchases of T-bills, increasing the rate on the Fed’s Reverse Repurchase Program (which has proven to be an effective floor for short-term yields in the past), Treasury issuance of Cash Management Bills and increased T-bill issuance.
As they did in March, the Fed and Treasury could, we believe, similarly alleviate downward pressure on short-term Treasury yields if they needed to do so in the future.
Negative-yielding money market funds unlikely
The US money market fund industry has operated efficiently in a zero, or near zero, interest rate environment for years through waivers and expense reductions. If gross yields on money market funds fell below zero, money market funds could implement, with guidance and approval from the Securities and Exchange Commission (SEC), reverse stock splits or reverse distribution mechanisms (RDM), such as share cancellation. Although the SEC has not provided guidance with regard to RDM, Invesco would be prepared to adopt this method in the US if negative rates were to become a reality.
Nevertheless, we believe an industry shift to RDM would not occur quickly. Regulatory guidance and disclosures would likely be required. Systems might need to be updated and money market fund investors would likely be provided with an advance notice period to ensure an orderly transition. Under a negative interest rate regime, it is contemplated that constant net asset value (CNAV) money market funds would continue to transact at $1.00 using RDM, such as share cancellation.
In our view, this scenario is unlikely as we believe it is a path that policymakers do not wish to follow, and the money market fund industry would likely need guidance and sufficient lead time to adapt.
Conclusion: Negative rates don’t seem likely
A Fed NIRP regime is not currently in the cards, in our view. Fed Chairman Jerome Powell has stated that the Fed is very unlikely to adopt negative interest rates as a policy tool. The Fed has acknowledged that there may be significant legal and logistical hurdles that might need to be overcome to implement NIRP and the Fed and the Treasury have also shown that they are willing and able to intervene to prevent negative interest rates from becoming the norm. We believe the Fed and the Treasury have effective tools at their disposal to intervene in the future if negative yields arise.
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Fed funds futures are financial contracts that represent the market opinion of where the daily official federal funds rate will be at the time of the contract expiry. Fed funds futures are used by banks and fixed-income portfolio managers to hedge against fluctuations in the short-term interest rate market. They are also a common tool traders use to take speculative positions on future Federal Reserve monetary policy. The federal funds rate is the target interest rate set by the Federal Open Market Committee at which commercial banks borrow and lend their excess reserves to each other overnight.
With its Reverse Repurchase Program, the Federal Reserve sells securities to a counterparty subject to an agreement to repurchase the securities at a later date at a higher repurchase price. Reverse repo transactions temporarily reduce the quantity of reserve balances in the banking system.
Stock splits are an issuance of new shares in a company to existing shareholders in proportion to their current holdings.
The opinions referenced above are those of the authors as of June 11, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.