Negative interest rate policy is nothing new to the global landscape. It is destructive, not constructive by the general nature of its term. In March of 2020, the Federal Reserve took its benchmark rate down to zero and the next logical question is: what comes next? We had a dash for safety in March, extreme growth in government money market funds and cash treasury bills trading negative. That, in conjunction with the Fed Funds probabilities and market pricing, has sparked curiosity.

Treasury bill rates went negative in March 2020

Government money market funds

Background

In many of our client conversations, Negative Interest Rate Policy (NIRP) has been front and center. When you look at the current landscape, it should not be surprising that the market is looking for more from the Federal Reserve.

Market pricing is calling for negative rates

The Fed’s influence since March

In the discussion, especially now, it important to understand what the Fed will do – and there has been a ton of debate on what the Fed should do. We believe the recent discussion from the Fed has been one of fine-tuning potential next moves. Certainly, the recent rise in coronavirus has the market looking for more, along with a growing sense of Fed concern simultaneously.

Whether one agrees with the Fed’s actions or not since March, it is likely we would be worse off, had the Fed not acted. The fiscal side of the equation has been mixed for years; heading into the 2020 election it is unlikely to get better. The Fed needed to act and did.

From the early days of Fed movement in March with the first 50-basis point cut, Powell and other Fed members were clear on what the Fed was watching: financial conditions. We can go back to the financial crisis of 2008, 2018 year-end hiccup and the coronavirus pandemic of 2020, where the Fed was very quick to react to prevent financial conditions from tightening.

Goldman Sachs Financial Conditions Index: 2001, 2008, 2018, 2020

In our most recent white paper, The Federal Reserve’s Red Line, we walked through the history of Chairman Jay Powell, programs the Fed adopted and what some of the choices for additional rate policy are from here.

One does not have to look far to see the influence across markets of the Fed’s actions in 2020 across financial conditions:

• Rates (treasuries and mortgages)
• Credit levels and activity in both the primary and secondary markets
• Declining volatility, equity levels and the USD well off its high levels from the liquidity crunch in March

Volatility across rates, credit and equities 

Pandemic economic challenges run deeper than the Fed

The pandemic of 2020 presents unique economic challenges, with a very swift blow to Main Street, small businesses and local municipalities. Job losses have been unlike anything we have seen, with the requirements for individual and business cash flow enormous. We have heard the Fed express many times, stating that the Fed can “lend not spend.” The three phases of liquidity passed by Congress, including the recent CARES Act has helped, but time is not a friend of cash flow – especially with the ongoing challenges regarding reopening amidst the virus.

The Fed will not solve cash flow and solvency issues and the improvement in financial conditions will not bring people back to work. The Fed has consistently pointed to the fiscal side of the equation.

Getting cash into the hands of small and medium size businesses has been a challenge. The Fed’s lending programs have been slow to implement and not widely used to date, and the Paycheck Protection Plan has helped in some, not all instances.

Powell and the committee have been clear about two things beyond their own initiatives:

• The fiscal side should not back away right now;July expirations with pandemic unemployment insurance and 30 million still on unemployment insurance including pandemic coverage.
• The health side heading into the second half of the year will be just as important as the monetary side. Certainly, the recent increase in cases has amplified that theme; on this, Dallas Fed President Kaplan has been especially vocal. Yet, the more we struggle with the virus, reopening and entering a highly contentious political season, all eyes remain on the Fed for potential next actions.

The Fed minutes from June

The Fed released their minutes from their June meeting early this month. While minutes in normal times are generally uneventful, these are not normal times. With the increase in coronavirus cases and the interest rate forwards pricing in negative yields, the market is searching for the next move from the Fed.

Forward guidance: Now a standard tool and a likely next move

The Fed: “In their discussion of forward guidance and large-scale asset purchases, participants agreed that the Committee has had extensive experience with these tools, that they were effective in the wake of the previous recession, that they have become key parts of the monetary policy toolkit, and that, as a result, they have important roles to play in supporting the attainment of the Committee’s maximum- employment and price-stability goals.”

AmeriVet Securities: The Fed discussed two forms of forward guidance: outcome based (inflation, employment or both) and calendar based. In listening to recent Fed speak (Powell included), informal forward guidance has already been given. The Fed has indicated the likelihood they remain on hold through at least 2022 and in Powell’s recent semi-annual testimony, he was clear he wants the employment market back to levels from February of this year (3.5%, U3 Unemployment Rate).

As the reopening progresses and the economic data continue to unfold, we would look for the Fed to issue more formal forward guidance in the coming months. With the Fed pushing back toward the fiscal side, in consideration of the discussions in Congress this month, it is unlikely to come at the July 29 meeting – although the message from the Fed has been consistent of late.

More specifically with forward guidance, the minutes seem to imply a stronger inclination to link policy to the Fed’s symmetric 2% inflation target. In fact, some Fed members favored allowing inflation to run above its target. Keep in mind the Fed’s policy review which will soon be completed. The Fed has been favoring the inflation side of the equation since the 2019 pivot. With the employment outlook highly uncertain, this could be a cleaner way of expressing forward guidance and it would be consistent with much of the Fed speak prior to the pandemic. The Fed’s been missing their inflation target since the financial crisis of 2008; tying the myriad and complexity of the Fed’s recent programs to inflation may be the best way forward.

The Fed’s Favored Core Personal Consumption Expenditures Price Index: 2006 – present

Large scale asset purchases: QE, now a standard tool

The Fed: “These participants noted, however, that large-scale asset purchases could still be beneficial under current circumstances by offsetting potential upward pressures on longer-term yields or by helping reinforce the committee’s commitment to maintaining highly accommodative financial conditions.” “These purchase amounts were significantly lower than the peak pace in mid-March and roughly corresponded to monthly increases in SOMA holdings of approximately $80 billion in Treasury securities and $40 billion in agency MBS. Continuing to increase holdings at this pace would likely help sustain the improvements in market functioning an seemed to be roughly in line with market expectations for Treasury purchases, and toward the lower end of expectations for agency MBS purchases, net of reinvestments. In addition, principal payments from agency debt and agency MBS held in the SOMA portfolio could continue to be reinvested in agency MBS.”

AmeriVet: The Fed has reduced its SOMA purchases, but clearly remains committed to maintaining a certain level of growth going forward, with a continued eye on market functionality. The Fed seems intent on underwriting a certain amount of traditional Treasury debt related to the fiscal costs from the pandemic. Recently, we saw a steepening of the yield curve with the move higher in risk assets as the economy was in the beginning stages of reopening. We believe the Fed wants financial conditions and long end rates low for quite some time and will increase purchases again if necessary.

Yield curve targeting

The Fed: “In their discussion of the foreign and historical experience with [yield curve targeting] YCT policies and the potential role for such policies in the United States, nearly all participants indicated that they had many questions regarding the costs and benefits of such an approach. Among the three episodes discussed in the staff presentation, participants generally saw the Australian experience as most relevant for current circumstances in the United States. Nonetheless, many participants remarked that, as long as the Committee’s forward guidance remained credible on its own, it was not clear that there would be a need for the Committee to reinforce its forward guidance with the adoption of a YCT policy.”

AmeriVet: The Fed is not convinced on the need for yield curve targeting. The Australian’s adopted yield curve control in 2020, targeting the three year part of the curve with a 25-basis point cap. Unlike what we have in Japan further out the curve and our thoughts are consistent with the Fed minutes, if the Fed eventually adopts YCT they will aim inside of five years. This would be consistent with the other initiatives the Fed has adopted (corporate bond purchases and lending facilities are four years and under) and Powell’s latest comments about the Fed looking at purchases as buy and hold. The more assets that can mature off the Fed’s balance sheet in the shortest timeframe, the better. Lastly, YCT could wind up being at odds with forward guidance and the implied change in policy stance should the economy meaningfully recover.

Negative interest rate policy

The Fed: “The expected path of the federal funds rate for the next few years, based on a straight read of overnight index swap quotes, declined a bit and remained close to the ELB through late 2023. Market-implied forward rates referring to 2021 and 2022 turned slightly negative for a few days beginning on May 7, though market commentary suggested that this development did not reflect investors expecting the FOMC to lower the federal funds rate target range below zero. This view was supported by Federal Reserve communications that negative interest rates did not appear to be an attractive policy tool.

AmeriVet: In many of our client calls lately, we have been asked about the potential for a negative interest rate policy. In the end, our view has been consistent: it is very unlikely, not impossible and very low in the food chain of current Fed tools. Nothing in the Fed minutes or recent public comments goes against this grain. The Fed needs the banks right now; after taking bank reserves above $3 trillion in three months, a negative rate policy would contradict everything the Fed has been looking to achieve within this window of time. It would be punitive for both banks and the consumer, and it is not what the economy needs right now; negative rates would accomplish little in bringing 15 million people back to work. More practical economies that have adopted negative rate policies have still struggled economically.

Where is the Fed’s head at right now?

The most recent Fed speak suggests a growing concern over the economy in the second half of 2020. Growing Coronavirus cases, coupled with recent decisions of certain parts of the country to reverse reopening momentum, has leant to caution on the part of the Fed. This all comes despite strong job gains driven by the reopening in May and June. The jobs momentum clearly at risk if more parts of the country shut back down.

On July 14, Federal Reserve Governor Lael Brainard gave a speech on Navigating Monetary Policy through the Fog of COVID, which caught the market’s eye.

Below is a look at some excerpts from his speech:

• A thick fog of uncertainty still surrounds us and downside risks predominate. The recovery is likely to face headwinds even if the downside risks do not materialize, and a second wave would magnify that challenge. Fiscal support will remain vital. Looking ahead, it likely will be appropriate to shift the focus of monetary policy from stabilization to accommodation by supporting a full recovery in employment and a sustained return of inflation to its 2 percent objective.
• Some high-frequency indicators tracked by Federal Reserve Board staff (including mobility data and employment in small businesses) suggest that the strong pace of improvement in May and the first half of June may not be sustained.
• Nonetheless, with inflation coming in below its two percent objective for many years, the risk that inflation expectations could drift lower complicates the task of monetary policy.
• With the policy rate constrained by the effective lower bound, forward guidance constitutes a vital way to provide the necessary accommodation. For instance, research suggests that refraining from liftoff until inflation reaches two percent could lead to some modest temporary overshooting, which would help offset the previous underperformance. Balance sheet policies can help extend accommodation by more directly influencing the interest rates that are relevant for household and business borrowing and investment.
• Forward guidance and asset purchases were road-tested in the previous crisis, so there is a high degree of familiarity with their use. Given the downside risks to the outlook, there may come a time when it is helpful to reinforce the credibility of forward guidance and lessen the burden on the balance sheet with the addition of targets on the short-to-medium end of the yield curve. Given the lack of familiarity with front-end yield curve targets in the U.S., such an approach would likely come into focus only after additional analysis and discussion.

On July 7, Federal Reserve Vice Chairman Richard Clarida, discussed forward guidance, LSAP and the desire for the Fed to do more on CNN International:

“We have a lot of accommodation in place; there’s more that we can do, there’s more that we will do, if we need to.