Are U.S. interest rates heading into negative territory? We don’t think so.

Jacob Manoukian
Global Market Strategist

Thomas Kennedy
Executive Director, Global Head of Macro and Fixed Income Strategy

Sam Zief
Head of Global FX Strategy, J.P. Morgan Private Bank

Our Top Market Takeaways for May 15, 2020.

It looked like it could get ugly


By mid-morning on Thursday, the S&P 500 was down over -5.5% on the week. Small cap stocks were down -11.5%. Sentiment was sour, and we couldn’t wait for Friday. What’s to blame?

  • Dr. Anthony Fauci poured more cold water on the idea that there would be a quick resolution to the COVID-19 crisis at a congressional hearing.
  • Investing titans like Stan Druckenmiller and David Tepper cited excesses in the stock market.
  • South Korea had to reclose bars and nightclubs after a flare-up in new COVID cases.
  • Los Angeles will probably not reopen until after July 4.
  • And finally…another three million Americans applied for unemployment insurance.

Bank stocks were the main character this week. By 10:00 a.m. on Thursday, U.S. banks had lost -13.5% throughout the week. Investors seem concerned about three main issues: the prospect of dividend cuts, reserve builds (banks have to add reserves in time of economic stress; when they do this, they can’t lend as much, which lowers their profits), and the threat of negative interest rates in the United States (more on that in a bit).

However, bank stocks reversed course and ended Thursday up almost +4%. The entire stock market took their lead. The S&P 500 ended Thursday up about 1% on the day, as did the NASDAQ, and small cap stocks even eked out a gain after being down by roughly -4% at one point. There was no clear catalyst for the move, but it seems notable that stocks had every justification to sell off further, but didn’t.

The day-to-day price action seems intense, but when you zoom out, the stock market seems to be stuck in a relatively narrow range, as do high yield and investment grade credit spreads and U.S. Treasury yields. As we mentioned last week, the dust from the first phase of the crisis is settling, and bulls and bears are fighting over where we go from here.

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Are U.S. interest rates taking a turn for the negative?


As worries over the economic fallout from the COVID-19 crisis have intensified, investors have priced in negative policy rates in the United States (for a refresher on what this even means, see our piece from last November). In fact, some options traders are even betting that the federal funds rate will be as low as -0.70%! This is surprising because the effectiveness of negative interest rate policy (NIRP) has been debated for years, and most economists agree that it just isn’t right for the United States. In fact, just this week, Fed Chair Powell went out of his way to reiterate that NIRP is not a tool the Federal Open Market Committee is considering. That being said, we think negative interest rates are very unlikely in the United States, especially given that the Fed has better tools to use to stimulate the economy.


Here are three questions we’re getting on negative rates, and our answers.

Q: Why would a central bank choose to set policy rates in negative territory?

When central banks want to stimulate the economy, they lower short-term interest rates. When you push policy rates lower, you incentivize people to spend (because they are earning less interest in their checking/savings accounts) or to borrow (because they have lower interest costs). In central banker speak: You ease financial conditions to stimulate economic activity.

It might sound odd, but negative interest rates, while newer to the economic ecosystem, still follow this framework. In theory (and big stress on “theory”), bringing policy rates below zero—say from 0% to -0.25%—should be largely the same as lowering rates from 0.25% to 0%. Further, some argue that negative rates actually amplify easy central bank policy. Because negative rates mean your average bank would have to pay to park their excess capital at a central bank like the Fed, NIRP could incentivize such banks to lend more, or to purchase assets at longer maturities or with lower credit quality (in order to make a profit). Second, breaking the “zero lower bound” (when short-term policy rates are set below zero) also helps to keep long-term interest rates low because investors have to price in the probability that rates, too, are below zero in the future.  

Q: What are the challenges of negative interest rates in practice?

Turns out, there is a big gap between theory and reality for three key reasons.

1. Bank profitability is challenged. This has been particularly acute, as banks in NIRP jurisdictions (the Eurozone, especially) have been hesitant to pass on negative rates to end consumers (like businesses or your average person who wants to borrow and invest). In effect, banks have chosen to shelter their depositors from negative rates at the expense of profitability—shouldering the costs of negative interest rates themselves. With lower profitability, the ability to absorb any loan losses is compromised, and that inhibits banks from making future loans, which in turn hurts economic growth. From there, the merry-go-round continues.

The chart shows the change in net interest margins from 2015 through 2019 to reflect the profitability of banks. It depicts the Eurozone, Sweden, Switzerland, Denmark, Japan and the United States over this time period.

2. Money market funds struggle to operate with negative interest rates. The U.S. money market fund industry is an important part of financial plumbing. Savers use it to park cash, and businesses and financial institutions rely on it for short-term borrowing. Currently, it is nearly ~$4 trillion. Roughly 75% are government and Treasury-only products (i.e., very safe); importantly, these carry a fixed-rate net asset value (you put in a dollar today and get at least a dollar back in the future). But if you have negative interest rates, a fixed-rate NAV is not possible.

3. Rates can’t go that negative. At some point, a very negative interest rate incentivizes people to hold hard currency (like bundles of bills under the mattress). Of course, stockpiling currency and keeping it safe comes with a cost: ECB research suggests -0.75% is the point where citizens will rotate from deposits to holding cold, hard cash. 

Q. So what could the Fed do if economic conditions intensify?

Long story short, we think it would do a lot of other things before it took the federal funds rate to negative territory. Beyond taking Chair Powell at his word, the frictions between NIRP theory and reality are significant, and we think the Fed has better tools.

Negative rates look like they would be a step in the wrong direction, and we don’t expect the Fed to take it.

In fact, the Fed doesn’t even need to really flex its muscles—it can just say it will do something. This is what central bankers call “credibility.” Case in point: The Fed has been able to effectively cure a liquidity crunch in a matter of two months (a feat that took it 6.5 months post–Global Financial Crisis). Furthermore, liquidity conditions have been restored to pre-COVID-19 levels merely on the promise that the Fed will act; so far the Fed’s alphabet soup facilities have only extended ~$125 billion of loans (a mere 2% of the Fed’s balance sheet).

The line chart depicts the LIBOR OIS spread as a percentage, comparing the COVID-19 era in 2020 to the Global Financial Crisis era in 2008–2009. It indicates that, comparing 2020 to 2008–2009, the spread has reduced at a quicker rate in 2020, which signals that the Fed has been able to help with the liquidity crunch more effectively than in 2008–2009.

If things did turn south, we think the Fed would be more likely to increase its purchases of mortgage-backed securities (MBS). The depth and efficiency of the U.S. MBS market is unique. The market gives the Fed a direct channel to impact average Americans where it matters most: their mortgage payments. When the Fed buys MBS, it drives their prices up and their yields (mortgage borrowing costs) down. As of year-end 2018, there was about $11 trillion of home mortgages in the United States—if mortgage rates were to go down by 1% and everyone refinances, $110 billion of aggregate disposable income would be available to consumers. There is political beauty here too, as Main Street is the direct beneficiary.

Any quantitative easing program would naturally include buying Treasuries too, but the ability to buy MBS is critical. The total agency MBS market is ~$8.5 trillion, of which the Fed owns ~$1.5 trillion. There is a ton of room to expand in this area.

The Fed’s policy response to the COVID-19 crisis thus far has been impressive. Negative rates look like they would be a step in the wrong direction, and we don’t expect the Fed to take it.

All market and economic data as of May 2020 and sourced from Bloomberg, FactSet and Gavekal unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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