Betting on zero: The road to negative rates
GlobalCapital’s Sam Kerr takes a deep dive on the history that put the Fed on its current path and examines what record low rates are doing to domestic and international credit markets
After a series of false starts earlier this year, views diverge on what direction the US Federal Reserve is going to take at this month’s meeting of the Federal Open Market Committee, and whether rates will rise or “lower for longer” will win the day. Key indicators of economic health, such as inflation and employment, remain below the central bank’s targets.
But whatever market players think may happen, the current era of record low interest rates is, without a doubt, unprecedented. Though data supports the idea that the Fed could actually cut rates further this month, some believe that it will raise rates just to give itself the ammunition to battle another crisis, with the ability to lower them again in the future if needed.
Others, however, see the possibility for lower rates or even negative rates over the long term. How did we get here, and what does this mean for the future of the economy? GlobalCapital’s Sam Kerr takes a deep dive on the history that put the Fed on its current path and examines what record low rates are doing to domestic and international credit markets.
The US Federal Reserve is the beating heart of the global economy, the world’s most important and dominant economic institution since the fall of the Soviet Union. But as important as the Fed is as an institution, it is the choices of its leaders that capture the imagination and make, or break, the global economy.
Over the last five decades, the Fed has been helmed by some of the most domineering figures in financial legend: Paul Volcker, the great anti-inflation warrior Alan Greenspan the man who Fortune magazine likened to God and Ben Bernanke, the man who steered the country through the recession and salvaged the economy from the rubble.
Given the fabled reputations of her predecessors the Fed’s current czar strikes a markedly different tone.
Prior to being appointed as Fed chair, Janet Yellen served as president and CEO of the Federal Reserve Bank of San Francisco and was a voting member of the Federal Open Market Committee (FOMC).
Despite her credentials, Yellen is often painted by critics as dovish and timid. Her tenure as Fed chair has been characterized by a reluctance to raise interest rates an act that could reward US savers and help investors, while also enhancing the Fed’s ability to respond to new shocks.
However, the path being taken by the Fed as it steers the US economy out of the worst recession in generations is, to some, the natural progression of the policies undertaken by Yellen’s predecessors.Danielle DiMartino Booth spent almost a decade as an advisor at the Federal Reserve Bank of Dallas and was involved in the policy-making process in her time at the central bank. Speaking with GlobalCapital, she said that far from being an outlier, Yellen’s Fed is treading the same path it has for the last three decades.
“I look at the Fed since Volcker left as being a progressive movement,” said DiMartino Booth. “Alan Greenspan was hesitant to upset the applecart, so he introduced the idea of gradualism [the idea that a central bank adjusts interest rates slowly in response to changes in its targets] which really hadn’t been institutionalised until Greenspan came along. As we know, that policy in particular helped stoke the dot-com bubble and it really exacerbated the problem in terms of inflating the housing bubble. So I think that was the first step.”
“Bernanke took one more step down the ladder and went from being gradual to malleable. If you look at why Yellen never wants to raise interest rates, you have to ask: why did Bernanke never want to stop quantitative easing and why it took so long for them to step back from it.”
The road to record low rates had been paved by previous Fed chairs, but anyone watching the central bank since the Great Recession of 2008-2009 cannot fail to see the profound effect that the crisis had on the institution.
The near collapse of the financial services sector on the back of the subprime mortgage crisis shook the Fed to its core and caused many to question the neoliberal economic policies that had guided western economies for decades.
While there has been opposition to the policies enacted by Yellen, as well as Bernanke before her, it is likely that without them the US economy would have declined further in the wake of the crisis, and the banking sector would have taken longer to come back from the brink.
“Yellen’s operating environment has been unique. So I think everybody has a great deal of sympathy in the sense that the US is in uncharted waters now,” says economist Tim Kane a research fellow at the Hoover Institution at Stanford University. “The same could have been said of Ben Bernanke’s tenure as Fed chair, as well, and the fact that there wasn’t a global meltdown is to his credit. But it is really too soon to judge whether the decisions that have been taken were the right ones. In the short term, the US avoided a second recession after 2009, yet without much in the way of recovery, the historical timing of recessions suggests that another is overdue,” Kane added. While investors and economists agree that the US economy could be looking at anemic growth for the foreseeable future, another recession is no sure thing. While the economy moves in cycles, or a series of peaks and troughs, it does not mean that the US should expect a recession just because it has enjoyed a prolonged, albeit small, period of growth.
According to Joseph Gagnon, a former associate director in the Division of Monetary Affairs at the Fed and now a senior fellow at the Peterson Institute for International Economics, there is no reason to think that the last five years of limited growth must inevitably be followed by a downturn.
“Most economists think that there is no sense in the view that just because it has been a while since a recession you will likely have one soon,” he said. “That said, in a typical year there is a 20% chance of a recession and they are not predictable. But because they aren’t predictable you can’t say we are due for one because there hasn’t been one in a while.”
Inflating the bubble
Yet, some argue that the path undertaken by the Fed may be increasing the risk of another recession, and that it may have driven the growth of a credit bubble in international markets, as institutions scramble to borrow at historically cheap rates. The Fed’s era of low interest, as well as the emergency actions which it took in the wake of the Great Recession, has led to some of the lowest financing costs in history. Corporate indebtedness, as a result, is surging to hair-raising levels. The low cost of borrowing has driven a surge in mergers and acquisitions activity, with companies targeting aggressive growth on the back of the ability to finance enormous M&A transactions.
US corporate borrowing was near the highest historical levels from 2012-2014. At the beginning of this year, Standard & Poor’s reported that US companies’ debt-to-earnings ratios stood at 12 year highs. The increase in corporate borrowing has coincided with a jump in debt issuance, with US corporate debt hitting $29trn at the start of 2016.
Increasing borrowing has also led to an increase in the issuance of securitized debt, particularly in the CLO sector. The CLO market saw record issuance of $116.2bn in 2014. The only two years in which CLO issuance surpassed the $80bn mark were 2006 and 2007.
The recent spike in issuance has followed a similar path, rising dramatically following three years of near zero interest rates. The data suggests that there is a correlation between a low federal funds rate and rising levels of debt being sown throughout the economy via securitization.
And while rising corporate debt has been a focal point in the years following the crisis, there is a parallel that can be drawn between the current era and 2008, which was preceded by lower interest rates between 2000-2006. Some argue that it is not possible to draw such a comparison, as the crash was driven by huge defaults on mortgage credit, and that there has never been a widespread occurrence of US corporate defaults.
Securitization has, for better or worse, spread this leverage across the marketplace. US corporate debt is now held by investors ranging from the world’s largest banks, to sovereign wealth funds, to public pensions. Given the surge of M&A and borrowing on the back of aggressive earnings and heady growth forecasts, any slowdown in economic growth is problematic for companies whose debt repayments rely on rapidly increasing earnings.
Kane notes that the increasing levels of corporate indebtedness are perhaps a more important metric for the Fed to consider when looking at rates, rather than inflation, which has become a preoccupation for central bank observers.
“I worry a lot more about debt bubbles than inflation - particularly global and national debt bubbles. And I think low interest rates, which the Fed sets and the rest of the world follows, has enabled these debt bubbles worldwide.”
The bursting of another large debt bubble has the potential to send a still fragile US economy careening towards another recession. When looked at alongside a slowdown in the Chinese economy, the exodus from high yield and the continuing turmoil in oil and commodities, rising corporate debt as a result of easy money has potentially dire ramifications.
Regardless of the cause, some are convinced a recession is lurking around the corner.
“I don’t think we are in recovery anymore, I think we are veering into recession and that has got Yellen really worried,” says DiMartino Booth. “The lesson that has not been learned, which has been disastrously lost on policymakers, is that if they allow markets to become quiescent and complacent then bad things will happen.”
With the collapse in the price of oil and other commodities, CLO managers with large exposure to those industries cannot afford to be hit by company failures in other sectors. There is often talk of unintended consequences, but there is evidence that the Fed knew of the risk that sustained low interest rates could lead to a highly levered economy.
“When economic resources finance more speculative activities, the risk of a financial crisis increases - particularly if excess amounts of leverage are used in the process,” wrote The Federal Reserve Bank of St Louis in 2011. “In this vein, some economists believe that banks and other financial institutions tend to take greater risks when rates are maintained at very low levels for a lengthy period.”
Lower for longer can stimulate economic growth, but if cheap borrowing is maintained for too long it can lead to severe problems when the economy finally slows.
Given that interest rates are hovering near zero, there are a limited number of options available to the central bank if the economy begins to experience a downturn. This has led to the discussion of negative interest rates, a situation which would be unprecedented in US history.
But given that this is the path embarked on by other central banks, particularly the European Centra Bank and the Bank of Japan, negative rates are no longer a joke but a stark reality.
Writing for the the Brookings Institute in March, Bernanke took a positive view on the potential for negative rates.
“The anxiety about negative interest rates seen recently in the media and in markets seems to me to be overdone,” Bernanke wrote. “Logically, when short-term rates have been cut to zero, modestly negative rates seem a natural continuation; there is no clear discontinuity in the economic and financial effects of, say, a 0.1 percent interest rate and a -0.1 percent rate. Moreover, a negative interest rate on bank reserves does not imply that the most economically relevant rates, like mortgage rates or corporate borrowing rates, would be negative; in the US, they almost certainly would not be.”
In typical fashion, views on this issue diverge. Perennial Fed critic Jeff Gundlach, founder of California bond fund DoubleLine Capital, called negative rates “the stupidest idea I have ever experienced” in an interview with German financial newspaper Finanz und Wirtschaft.
Economists also disagree with the idea that there are long term benefits from negative rates.
“There aren’t any tools the Fed has to deal with another crisis, and we shouldn’t pretend there are. The standard rules of monetary stimulus and fiscal stimulus won’t be available,” says Kane. “Those negative interest rates are theoretically possible but there is a limit to it. You can use negative interest rates in big financial markets, but in consumer markets you really can’t.”
However, Gagnon, who spent years at the US Federal Reserve, notes that the perception of negative interest rates might be worse than the reality.
“I think the Fed does have tools and I don’t think that negative rates are as bad as people are saying. I think that they are working to some extent almost completely like normal rates do. Small depositors aren’t seeing negative rates yet and maybe they won’t,” said Gagnon.
Negative rates are still only a distant possibility, and would likely not be brought into effect if inflation remains low. This will likely remain the case as long as investors continue to view US debt as a safe haven, though any drop in confidence could lead to a rise in inflation if US debt purchases shrink.
While some remain unconvinced US Treasuries will ever lose their luster, a dramatic change in monetary policy could make them less attractive.
Leading up to his nomination as the Republican presidential candidate, Donald Trump announced on CNBC that he would dramatically increase US borrowing on the presumption that if the economy faced a severe downturn he could strike a deal with creditors. Such a policy view from a presidential candidate is unprecedented and could severely damage confidence in US government debt.
The issue of cutting rates to zero or less is perplexing, and the legality of the measure is still questioned by some.
But according to financial historian and a legal scholar Peter Conti-Brown, an assistant professor of legal studies and business ethics at The Wharton School of the University of Pennsylvania, the Fed would likely be able to implement negative rates if the situation called for it.
“I think this is a close question but yes [negative interest rates would be legal],” said Conti-Brown. “The Fed has remarkable discretion in calculating the ‘fees’ it charges banks for ‘services’ it provides.”
The Fed’s long road to negative may be a self-fulfilling prophecy, with the low interest rates initiated in the shadow of the last recession laying the groundwork for the credit bubbles which could initiate or even cause the next one.
Given the magnitude of the 2008 crash, it is unclear whether the Fed could have done anything different. But negative rates might be the only tool available to the Fed if the next recession turns out to be sooner or worse than expected.