Negative U.S. interest rates could be the norm next year and all through to 2023 if fed funds futures are any indication. Or it could just be traders hedging their bets.
Fed funds futures have implied negative rates next year on-and-off since May, when the contracts priced them for the first time. They flipped back to show positive rates, but over the past month, futures contracts at different points have again signaled negative rates as early as spring 2021.
Futures are now betting interest rates could go below zero all the way to June 2023.
“We’re sitting here with real economic turmoil and what the market is saying is that the risks could be bad enough that the Federal Reserve could be forced to take rates negative,” said Stan Shipley, fixed income strategist, at Evercore ISI.
On Thursday, fed funds futures [0#FF:], a gauge of where markets expect the Fed’s benchmark overnight lending rate will be at different intervals, has priced in negative rates of about half a basis point in July 2021.
That doesn’t mean it will happen. Federal Reserve officials have so far uniformly rebuffed them, with the latest rejection coming on Tuesday as Fed Governor Lael Brainard said negative rates are not an attractive option for U.S. monetary policy.
Negative interest rates have been used in Europe and Japan as a further goad to lending by making it costly for banks to park funds with monetary authorities.
But negative rates also compress the margin financial institutions earn from lending and can have the effect of stopping them lending, eventually damaging the economy.
“There can be few ideas more abhorrent to the traditional fixed income investor than that of negative interest rates,” wrote Citi’s global markets strategist Matt King and global chief economist Catherine Mann in a report, adding the mere suggestion that investors might need to pay to lend “strikes at the heart of everything we thought we knew about finance.”
The Fed slashed the fed funds rates to near zero in March and launched numerous programs to boost liquidity and stabilize financial markets.
The fed funds market often misses the mark in accurately predicting where rates will be beyond the near term. In December 2018, the market was predicting a fed funds rate of nearly 3% a year later. By the time December rolled around, the rate was roughly half that after three rate cuts.
Still, pricing negative rates well into 2023 suggested investors are expecting a prolonged recession, dire enough that the Fed would consider setting rates below zero.
“People may be uncertain as to how long COVID will last so they’re targeting the (zero) floor to break,” said Gennadiy Goldberg, senior rates strategist, at TD Securities, adding that rates were being indicated as negative “a little bit further out now.”
There are indications that the much-hoped for V-shaped recovery may not happen. Fed officials on Tuesday cautioned about a slower-than-expected rebound.
“All of a sudden, the global economic data flow isn’t coming in with green shoots,” said Dave Rosenberg, chief economist and strategist at Rosenberg Research.
FOR NOW, A TECHNICAL MOVE
In May, analysts said the pricing of negative rates may be a sign traders were hedging their positions.
UBS said at the time that the move was likely accounting-driven, with banks trying to protect against a negative rates scenario.
The same hedging process is likely underway again.
“It’s a technical move,” said Subadra Rajappa, head of U.S. rates strategy, at Societe Generale. “It’s not nearly as deep as the last time when there was a lot of hedging related to the zero lower-bound.”
Futures contracts on the back end also have very little liquidity. The December 2021 contract has priced in a fed funds rate of minus 2 basis points, but there were just 21 contracts traded on Monday, said TD’s Goldberg.
What could shake rates sentiment, however, still lies with the Fed.
“I would wait for a shift in the Fed’s monetary stance in their speeches, that they are more inclined to adopt negative rates,” Societe Generale’s Rajappa said. “But until then, I wouldn’t read too much into the fed funds futures.”