Negative interest rates and government bond curves

In the past few weeks, nominal interest rates at the very front end of the US yield curve have shifted marginally into negative territory for the first time. Although negative policy rates have become commonplace in both Japan and Eurozone since the mid 2010s, and have extended to longer dated bonds, this phenomenon is still seen as a complete novelty in US markets.

With breakeven inflation rates generally remaining well anchored on the Fed's 2 per cent inflation target, and the FOMC unanimously having determined only last October that negative policy rates were still undesirable, investors had not, until lately, seen any reason why the US central bank would follow the ECB and the BoJ into negative territory. But the COVID-19 economic crisis may be changing that.

After cutting policy rates to the assumed minimum level on 15 March, the range for the fed funds policy rate has been left at 0.0-0.25 per cent, and is therefore centred at 0.125 per cent (or 12.5 basis points). Initially, fed funds futures traded close to that central rate or at least 12 months into the future, implying that the market expected policy rates to be left unchanged for a lengthy period.

However, forward rates started to fall further in late April, and the 12-month forward rate actually fell very slightly into negative territory in early May, when doubts about the strength of the economic recovery began to rise. Furthermore, Harvard Professor Kenneth Rogoff released an influential article, arguing that the Federal Reserve should seek to cut policy rates "deeply" below zero - in fact, to minus 3.0% - in order to ease the monetary stance and reduce the burden of servicing much higher public and private debt after the pandemic.

One of the reasons that the Fed and some other central banks have opposed negative interest rates is that they believe there would be adverse consequences for bank profitability, which stem mainly from the expected behaviour of policy rates relative to both bank deposit rates and the shape of the yield curve. Based on experience in the Eurozone, it has been assumed that banks would not be able to pass the negative rates earned on their liquid deposits at the central bank on to small deposit holders, notably households. In addition, negative rates have caused a sustained flattening in the yield curve, probably the major determinant of bank profitability.

 

A small shift into negative territory for US policy rates, stopping at around -0.5%, would probably have the same impact as in both Japan and Germny, which is to flatten the yield curve as investors realise that short rates are likely to persist below zero for a very long period of time. According to the expectations theory of interest rates, long rates should be equal to the expected path for (annualised) short rates, plus a risk premium (which can itself be positive or negative).

After a shift in the fed funds rate to -0.5%, the market is quite likely to build in the expectation that policy rates will remain below zero for many years, and also require a negative risk premium for holding longer dated bonds. (This negative risk premium would represent the risk that policy rates might go even lower than -0.5% before the duration of the long term bonds reaches expiry.)

The overall easing in US monetary conditions that these reductions in nominal interest rate would entail would be rather small, and arguably not worth the damage to bank profitability, consumer confidence and money market stability that could follow such a dramatic shift in the nominal return on monetary assets.

This is probably why Chairman Powell continues to say that negative rates are not supported either by himself, or by any other member of the FOMC at present.

However, the subject is far from closed. A much larger shift in policy rates below zero might be possible if the Fed were willing to consider introducing the reforms recommended by Ken Rogoff. And the Bank of England, previously also a strong opponent of negative rates, seems to be reconsidering their position. This is a subject that will be watched carefully in future blogs in this series.