Once upon a time, it was inconceivable to contemplate the notion of negative interest rates in the U.S. It was laughable even. However, today we are in an unprecedented environment with a $17 trillion pile of negative yielding sovereign and corporate debt around the globe. A world of omnipresent economic uncertainties, a synchronized global growth slow down, and a trade war with no end in sight has central banks slashing interest rates in a race to the bottom, despite a decade of quantitative easing that has not had the desired effects. But with talk percolating about the possibility of negative interest rates in the U.S., it begs the question as to what asset classes will be likely winners should interest head far south.
It is no longer far-fetched to think that the U.S. – the last man standing in the developed world with yields above 1% – could see its nominal rates fall below zero. But for now, it is the U.S. versus “The Rest of the World.” Europe has been experimenting with negative interest rates for some time (parts of the Eurozone have had negative rates since 2014) in their efforts to spur anemic aggregate demand in both consumption and investment, neither of which have fully recovered since the Global Financial Crisis of 2008. Japan followed suit in 2016 but has already held rates at 0% for 20 years. Perhaps more importantly, powerful secular forces of demographic change, and rapid technological advancements are suppressing inflation and contributing to a savings glut in all corners of the world.
Nevertheless, the introduction of negative interest rates domestically would be extremely premature and unlikely to happen in the short or medium term, in our view, despite at least three additional rate cuts being “priced-in” by the market. Conventional wisdom dictates that interest rates should reflect the state of the underlying economy and today, the fundamental macroeconomic data does not support such extreme measures from the Federal Reserve (Fed). Unemployment is near a 50-year low, inflation is contained, and growth, though moderating, is still in the 2% range. Notably, the consumer remains healthy and a robust component of the economy as various data sets, including consistently strong retail sales, continue to demonstrate.
Despite the persistent recession obsession among the media amid several information cross currents, recessions are difficult with a healthy consumer and supportive monetary policy. The economy would have to get much worse for the Fed to justify suddenly dropping interest rates by over two percentage points. Janet Yellen stated as much back in 2016 during her tenure as the Fed’s Chair when asked about the possibility of going to negative rates and it is challenging to envision Jay Powell abandoning this perspective in the current environment.
It still remains to be seen if negative interest rates will accomplish their intended stimulus. They have failed to boost European growth so far or shift investments away from government bonds to something more economically productive. They have also not cured Japan’s deflationary malaise. And we are going to have to wait and see what damage may be done by this experiment as the ills, such as likely asset bubbles, unprofitable banks, and needlessly punished savers, may outweigh the benefits. What is very clear is that the main beneficiary of negative rates abroad will be U.S. credit markets and U.S. dollar assets broadly.
As negative rates spread in space and time — from core European countries out to the periphery and impact both shorter and long duration sovereign bonds — the dearth of investable, “safe” assets will drive capital flows into the U.S. This will inevitably produce yield pressures across domestic fixed income. However, we do not expect to see U.S. yields plunging to near zero or lower levels as the size, breadth, and liquidity of our capital markets – a key structural advantage – and the abundance of alternative investment products should counterbalance the spread compression.
We will be getting some insight into the Fed’s thinking on both its economic outlook and any further easing measures under consideration, should growth slow more than expected, at next week’s FOMC meeting, which feels like the most important one in years given the rapid trade developments. Another 0.25% interest rate cut is all but assured and the restart of its bond purchasing program is also likely. However, despite the strong political pressure from the Trump administration, we believe that negative interest rates in U.S. will be staying in the realm of theory for some time.