If Fed opts for negative rates, it will be a ‘Hail Mary’

Should the U.S. Federal Reserve opt to take its benchmark funds rate into negative territory, it will need to “go deeply negative” with a cut of between 50-100 basis points below zero, according to Standard Chartered Bank.

The Fed has unleashed an unprecedented barrage of monetary stimulus in a bid to shore up the U.S. economy against the economic impact of the coronavirus pandemic. However, Chairman Jerome Powell has denied that taking its benchmark overnight lending rate below zero is under consideration, despite pressure from U.S. President Donald Trump.

Speculation of negative rates has nonetheless persisted, and although not the bank’s base-case scenario, Standard Chartered analysts said in a note Wednesday that it could occur in the event of a disappointing economic rebound and exhaustion of other policy options. They suggested that if negative rates were to emerge as a last resort, the central bank would need to go deep.

“No one likes trying a ‘Hail Mary’ from midfield as the clock ticks down when you are losing, but you kick the ball a long way in that situation – there is no point to a short pass,” said Steven Englander, head of global G10 FX research and North American Macro Strategy at Standard Chartered.

Negative interest rates, as seen in the euro zone and Japan, effectively charge banks to hold money with the central bank in a bid to encourage them to lend and therefore stimulate the economy. However, both the euro zone and Japan have seen limited benefits since their implementation, which was before the coronavirus pandemic erupted.

Englander argued that while central banks often present breaching zero as akin to “crossing the Rubicon,” there is not necessarily a “non-linear” policy impact that would make edging from a small positive to a small negative a significant monetary policy maneuver.

“If cutting policy rates from 150bps (basis points) to 10bps was not enough to shock the economy into recovery, we (and we suspect the Fed) do not think that going from +10bps to, say -20bps would materially affect the outcome,” Englander said.

“We doubt that the Fed expects a small venture into negative territory would provide enough stimulus to offset the negative impact on banks lending and disruption of short-term money markets.”

Englander suggested that dropping 50-100 basis points below zero would trigger a significant fall in yields on the benchmark 10-year Treasury note, along with easing debt-servicing pressures.

Standard Chartered analysts believe this would likely send Treasury yields to all-time lows across the curve, potentially taking the 10-year negative, especially since the policy action would likely be taken against a backdrop of a bleak economic outlook and rising deflation risks.

“Still, we would expect the move to be driven primarily by the real yield channel in response to the rate cuts and ongoing Fed U.S. Treasury buying,” he added.

Should the move to negative rates transpire, Englander anticipates a sharp fall in the U.S. dollar, with the timing of the drop dependent on the economic and asset market context.

“Negative rates could disrupt short-term money markets at first, so the initial response might be buying G10 safe havens, or even result in USD strength,” he said.

“Once the surprise element passed through the market, currencies with positive yield and muted fiscal policy should prosper.”

Meanwhile, gold would likely test all-time highs in this scenario, Englander projected, as negative interest rates would “lower the opportunity cost of holding gold.”

“Investors still appear to be under-allocated to gold, and negative rates could draw interest from retail to the official sector,” he added.