June 22, 2020
The European Central Bank (ECB) and the Bank of Japan (BoJ) both have negative rates. So why hasn’t the Federal Reserve (the Fed) followed suit? At a time when Covid-19 has brought world economies to a halt—and top government officials even argue in favor of negative interest rates1 — this is the question.
According to David Leduc, head of fixed income at Mellon, the question is an important one – but one that warrants a multifaceted answer. One reason, he says, is because negative rates in the US could undo post-Great Financial Crisis efforts to make banks more resilient to future shocks.
“Fed Chairman Jerome Powell has repeatedly highlighted the challenges of negative interest rates, including the impact on bank margins and profitability as it would be difficult to pass on these rates to depositors,” he says. “It also could encourage banks to pursue riskier lending activities, creating further risks and distorting markets.”
This is partially why Sweden’s central bank abandoned its negative rate policy at the end of 2019, after almost five years,2 he says. The Fed may also be reluctant because it could upset money markets, which, Leduc says, play a more prominent role in the US than in other large developed economies. “A contraction in the availability of investors in money markets would have negative implications for corporate borrowers and investors such as pension funds,” he says.
While additional reasons also exist, the picture becomes clearer when considering the variety of tools at the Fed’s disposal. Remember how it responded when the ‘black swan’ of Covid-19 descended upon bond markets earlier this year? It created nine lending and purchase programs to restore liquidity after credit markets froze. And as economic lockdowns put pressure on the natural flow of capital, the Fed used its Main Street Lending program to make it easier for small businesses and non-profit institutions to access credit.
Since the start of the crisis, the Fed’s balance sheet has ballooned from US$4trn to more than US$7trn3 — and while that’s a steep increase, it still has room to grow, according to Leduc. “On average, the Fed has tweaked its existing facilities at least once a week since they’ve been implemented, mostly expanding their scope and lengthening their duration,” he says. “Powell has noted problems with non-profits like hospitals and universities and is planning to do more for them.”
Then why is it still a topic of discussion?
While it’s unlikely the US will see negative rates in the foreseeable future, Leduc says, he understands the rationale as to why they might work. “They’re designed to increase economic activity by stimulating lending activity and reducing borrowing costs,” he says. “In theory, this would also contribute to a weakening US dollar, which would have several benefits to global growth, helping developing economies reduce their cost of servicing dollar-denominated debt.”
However, even for central banks that currently have negative rates, he and his team do not expect further cuts for now. The ECB hasn’t touched its deposit rate since September 2019, instead opting for other tools, like quantitative easing (QE) and reducing capital requirements for banks.4 Similarly the BoJ has shied away from lowering its policy rate, instead focusing on the expansion of its programs to support the availability of credit. In May, the BoJ announced a new program to support bank lending to small and medium enterprises (SMEs) which expands on existing programs to facilitate large purchases of corporate debt, ETFs and other assets, he says.
While the Fed’s counterparts have decided not to cut rates further in the near term, how is Leduc and the BNY Mellon Global Fixed Income team navigating an environment full of central bank loans and asset purchases?
Due to pandemic-driven market dislocations in March and April, corporate and high yield bonds dramatically underperformed government bonds as rates fell back and risk premiums skyrocketed, Leduc says. As policy responses materialized, he’s increased allocations to highquality issuers in sectors least impacted by Covid-19.
“We were able to take advantage of higher spreads in the new issue market as companies rushed to raise liquidity with new bond issues,” he says “While we increased our overall exposure, we have been careful to maintain a high level of portfolio diversification in an environment where idiosyncratic risks have only increased.”
Despite US policy rates approaching similar levels to those of Europe and Japan, he says US bonds, in both spread and overall yields, remain attractive in comparison—but adds the US isn’t the only place to invest in bonds. “We also continue to find attractive opportunities outside the US, specifically in peripheral European government debt and select higher-quality emerging markets,” he says.
He admits this is a different approach than if the Fed had implemented negative rates. If it did— then over the short term—the demand for higher yielding assets in US corporate bond markets would increase, prompting him and the team to increase allocation to those sectors, he says. But over the medium term, it could potentially create risks in sectors, such as banks, and distort financial market pricing, prompting him and the team to reconsider asset exposure and overall risk budgets, he adds.
However, this is not the case… at least for now. That said, how long can we expect this environment to persist before the Fed can actually raise rates again?
Easy does it
Most agree the pandemic will determine both the severity and duration of the crisis. While some expect a reversion to normality soon and some think it’s more of a long-term probability, the truth may lie somewhere in between.
“We expect growth to recover meaningfully in 2021 based on an expectation of the economy reopening. However, we also expect the impact of the crisis to continue to result in lower trend output over the next several years,” he says. “As a result, we think the Fed will remain in an extremely accommodative stance well into 2021 with the potential for policy to begin normalizing in 2022.”
1 Business Insider: Trump renews call for negative interest rates, says other countries are already enjoying the 'gift'. May 12, 2020.
2 WSJ: A Pioneer of Negative Rates Pauses the Experiment. December 19, 2019.
3 Federal Reserve: Credit and Liquidity Programs and the Balance Sheet. Accessed June 18, 2020.
4 Reuters: ECB cuts banks' market risk-related capital requirements. April 16, 2020.
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