Can US Interest Rates Go to Zero?-An Update
In my March 18, 2020 Pentegra Current Thinking blog, I evaluated factors both supporting and arguing against a sustained drop in US interest rates to zero or negative territory. Since then, rates have generally trended downward, but with significant volatility and also with periods where rates have risen. According to Freddie Mac, the average 15 year fixed mortgage rate in mid-April 2020 was 2.80%, versus 2.95% at the end of February 2020, with mortgage rates rising slightly in mid-March. The benchmark 10-year US Treasury yield fell below 0.5%, but then rose to 1.2% in March before retreating to 0.6%. The 30 year US Treasury yield fell under 1.0% after breaking through its 2% threshold, although it rose to 1.8% in March. The factors discussed in my March blog have been updated and can be classified as follows:
- Supports a sustained drop in US interest rates to zero (Y)
- Argues against a sustained drop in US interest rates to zero (N)
- Uncertain whether supports or argues against a sustained drop in US interest rates to zero (U)
- Coronavirus (Y): In addition to its significant human toll, the coronavirus pandemic has thrown global economies into recession and uncertainty. This has led to major Federal Reserve (“Fed”) rate cuts and investor flights to safety into Treasuries, gold, and cash. Global growth rates are expected to plunge in 2020, with economic recovery uncertain until the virus is contained and vaccines are available.
- Federal Reserve actions (Y): On March 3rd, the Fed cut its target rate by 50 basis points in an emergency move. On March 15th, the Fed, in another emergency move, cut rates by an additional 100 basis points, to near zero. The rate cuts were driven by global economic uncertainty from the coronavirus, financial liquidity concerns, expected economic contraction in the US and globally, and low inflation. In addition, the Fed has injected significant liquidity into the cash and fixed income markets. In April, the Fed provided up to $2.3 trillion in aid, including loans and support to government and corporate bond markets. The Fed’s balance sheet has also increased in the past year, by nearly two-thirds, to over $6 trillion.
- Low US inflation (Y): The aggregate US inflation rate by most measures remains well below the Federal Reserve target of 2%. In fact, the US economy has begun to show deflation, or falling prices. This is expected to be exacerbated by the collapse in energy prices. The “extra yield premium” which compensates for expected inflation continues to be very small.
- Fiscal policy (N): Large stimulus packages passed by Congress to provide financial support to households and businesses have nearly quadrupled the expected 2020 federal budget deficit to nearly $4 trillion, from $1 trillion at the end of 2019. While recent US budget deficits have had less than the expected impact on inflation and interest rates, increases in spending (e.g. direct payments, unemployment assistance, loans, aid to state and local governments) which are not funded by tax revenues might eventually lead to higher inflation and higher interest rates as the government issues more debt.
- Non demand-driven inflation (N): While inflation and higher interest rates are normally caused by greater consumer spending and economic expansion, the flip side is that higher prices may be the result of factors such as higher prices paid by consumers as a result of a run on goods due to the coronavirus, supply chain disruptions and tariffs on imported items such as food and electronics.
- Negative interest rates in developed countries outside for the US (U): Compared with a month ago, the same proportion of developed countries outside the US have negative government bond yields with a 2-year maturity (one half). The average yields for developed countries have declined slightly, and are currently at 0%, 0.3% and 0.6% for government bonds with 2, 5 and 10 year maturities respectively. Negative rates have been a function of low growth, low inflation and economic weakness. It remains to be seen whether further economic weakness and central bank easing will add to the countries with negative rates.
- Global demand for US Treasuries (U): China is one of the largest purchasers of US Treasuries, but the impact of the coronavirus, trade tensions and tariffs has reduced China’s appetite for these securities. The Federal Reserve has picked up the slack through recent liquidity programs.
- There are “hawks” on the Federal Reserve as well as “doves” (U): This is not an issue in the current environment. However, once there is a recovery in the US economy, hawks may believe that tightening, or maintaining positive interest rates, may be called for.
Given this complex set of factors, it is uncertain whether US interest rates are headed toward zero or will remain positive. As discussed the March blog, zero or negative rates could cause significant changes to our financial structure. When interest rates are positive, banks lend out a fraction of their deposits at a given rate of interest. People can then spend this money or deposit a portion into another bank, which then, in turn can lend, and so on. This is known as “fractional reserve banking”. However, if rates turn negative, people would pay banks to store their money, and there would be little incentive for banks to lend.
In a negative rate environment, rather than relying on fractional banking for growth, policymakers would need to hope that people will spend their cash as opposed to putting it under their mattresses. Investors may also decide to keep their savings in cash or valuables such as art and jewelry, or, conversely, they may increase their allocation to riskier investments such as stocks to get a positive yield. It would stand to reason that the US government would likely need to “reinflate” the economy through spending and money creation so as to re-establish positive rates.
Whether or not interest rates rise or fall in the next several weeks or months, its ultimate path, particularly in this unprecedented environment, will be closely watched but difficult to predict.
NOTE: Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Past performance is not a guarantee of future investment results.