Explainer: Fed funds futures market sees negative rates by next April

NEW YORK (Reuters) – The fed funds futures market is pricing in negative U.S. interest rates next year, a scenario the Federal Reserve has said it wants to avoid as many doubt that it would be an effective tool to stimulate growth.

Setting interest rates below zero would punish banks for leaving excess cash with the central bank. The hope is to encourage lending, in turn boosting business investment and consumer spending.

On Friday, the fed funds futures market priced in negative rates of about half a basis point in April 2021. [0#FF:]

The U.S. central bank slashed the federal funds rate to near zero in March and has launched numerous programs aimed at boosting liquidity and stabilizing financial markets as the U.S. economy reeled from the coronavirus pandemic.

ARE FED FUNDS FUTURES A RELIABLE PREDICTOR?

Not necessarily. Futures indicate market expectations, but those can change. Futures markets are also highly technical. They will not necessarily reflect what the effective fed funds rate that is bounded by the Fed’s target rate will be. It is currently 0-0.25{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f} and varies slightly as banks lend to each other overnight.

Analysts said that just because negative rates are being implied in the futures market does not mean it will happen.

“Even before rate futures went negative, the options markets also had a lot of interest in that,” said Mark Chandler, chief market strategist, at Bannockburn Global Forex in New York.

“If negative interest rates will kill your business, maybe you’re in the business of lending money, I can see how you want to have some insurance against negative interest rates. And this is how they want do it, through the futures market,” he added.

HOW DO RATES GO BELOW ZERO?

Central banks try to control interest rates using monetary policy, although supply-and-demand conditions in the market give investors influence.

A negative rate policy requires financial institutions to pay for depositing excess reserves with the central bank. By effectively penalize financial institutions for holding their cash, central banks encourage them to lend more.

The European Central Bank (ECB) launched negative rates in June 2014, cutting its deposit rate to -0.1{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f} to stimulate the economy.

The Bank of Japan (BOJ) introduced negative rates in January 2016, partly to prevent an unwelcome yen appreciation from hurting its export-reliant economy. It charges 0.1{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f} interest on a portion of excess reserves financial institutions park with the BoJ.

There are limits as to how deep central banks can push rates into negative territory. Investors can avoid being charged negative rates on deposits by choosing to hold cash instead.

WHY ARE NEGATIVE RATES BAD?

Negative rates compress the margin that financial institutions can earn from lending. If rates stay negative for long, financial institutions could stop lending, hurting consumers and businesses and eventually damaging the economy.

Negative rates also hurt savers. As returns from savings accounts fall, individual investors that rely on a fixed income may be pushed to invest in riskier assets such as stocks or corporate bonds to make ends meet. This puts them at greater risk of investment losses.

People trying to purchase a home can benefit from lower rates, but also suffer from higher home prices that result from cheaper loans. They also must save more for a deposit. Once they buy, they are exposed to losses if rates change direction and move higher, which typically pushes down house prices.

WHAT ARE THE BENEFITS OF HAVING NEGATIVE RATES?

Negative rates help lower borrowing costs. The biggest beneficiary would be the U.S. government, which has been financing its growing deficits with public debt.

The non-partisan Congressional Budget Office said last month it expects the U.S. federal deficit to nearly quadruple to a record $3.7 trillion this fiscal year, as the country combats the effects of the coronavirus outbreak.

Companies also benefit as they can borrow more cheaply and invest in growing their business. This investment, and greater liquidity from looser monetary conditions, typically raises stock prices.

Negative rates also result in cheaper mortgages, which attract new home buyers. They allow existing home owners to refinance loans at lower rates, reducing their debt obligation. Consumers can borrow at cheaper rates to finance other large purchases such as cars or home appliances.

Negative rates could also weaken a country’s currency, making exports more competitive. However, it also could boost inflation by raising import costs. Inflation can be good for manufacturers and producers because it raises pricing power.