What happens if the Fed cuts rates to zero -- or goes negative?

CNN Finance 1 month ago
Globally, trillions of dollars worth of bonds now have negative yields. CNN Business' Julia Chatterley explains what's driving this phenomenon.

Say what you will about President Trump's unusually loud critiques of Jerome Powell, his hand-picked chairman of the Federal Reserve. But Trump is not wrong when he says that interest rates in the United States, even after two recent cuts, are higher than they are in much of the rest of the developed world.

Now Powell is likely to face even more pressure to cut rates in the coming months -- especially since Trump's trade war with China appears to be hurting the US economy.

So let's get out our limbo sticks. How low can rates go? Could the Fed even cut into negative territory the way that the European Central Bank and Bank of Japan have done? More importantly, is that what the Fed should do?

    More rate cuts are likely as the US economy slows. This week's tepid ISM Manufacturing and services numbers, and a lower-than-expected jobs gain for private employers reported by payroll processor ADP are signs that the trade war is having a negative impact on the labor market.

    That's hit both the stock market -- which has stumbled this week -- and the bond market. The yield on the 10-Year Treasury fell to 1.51% Thursday and is once again inching toward record lows.

    Still, some question whether the US economy needs rates to go all the way to zero -- or below that. Conditions are not exactly dire. After all, the only other time the Fed slashed rates to zero was during the 2008 global financial crisis.

    "Will the Fed keep cutting rates marginally? Yes. But I don't expect a repeat of 2008," said David Page, head of macroeconomic research at AXA Investment Managers.

    The economy is weakening, but this isn't another Great Recession

    Page said he's penciling in one more rate cut this year -- probably in December. But he conceded that if there is more weak economic data, particularly in Friday's jobs report, then the Fed might cut rates in October and December. After that, he believes the Fed will stop.

    The market agrees. According to federal funds futures contracts traded on the CME, there is now a 90% probability of a cut at the October 30 meeting. That would push rates down to a range of 1.5% to 1.75%.

    Look out further and the market is pricing in a more than 85% chance of one more rate cut to 1.25% to 1.5% by April, but just a 50% likelihood that rates will fall to a range of 1% to 1.25 or lower.

    With that in mind, investors shouldn't expect rates to even drop as far as zero, let alone negative territory.

    "Could the U.S. experience what Japan and several countries in Europe have seen recently -- a combination of negative central-bank policy rates and negative nominal government bond yields? While this scenario is possible in the U.S., we believe it has a very low probability of occurring," said Luis Alvarado, investment strategy analyst with Wells Fargo Investment Institute in a report.

    Alvarado notes that there are legal questions as to whether the Fed even has the authority to lower rates below zero. He also pointed out that Powell and other Fed members have said they aren't a fan of negative rates.

    Lower rates aren't a panacea

    If anything, the Fed would be more likely to restart quantitative easing, the policy of buying Treasury bonds and mortgage-backed securities that it used during the financial crisis, as a way to push down long-term rates.

    Page said such a move would likely weaken the dollar. In theory, that could boost US exports and the profits of American multinational firms. But there's also this little thing called a trade war that's likely to dampen things for American companies no matter what happens to the dollar.

    Lower interest rates bring serious consequences that are probably weighing on the minds of Fed members, as well.

    Low rates discourage people from saving, since banks will likely slash the amount of money they pay on deposit accounts as interest rates tumble. That would hurt anyone who has more of their retirement savings in supposedly safer bonds or cash.

    And financial firms would be hurt as well.

    KBW analyst Fred Cannon noted in a recent report that earnings estimates for large regional banks -- such as Comerica (CMA), Zions (ZION), M&T (MTB) and Fifth Third (FITB) -- would plummet if interest rates continue to fall.

    That's because these banks won't be able to make as much money from loans in a lower (or negative) rate environment.

    Cannon said negative rates would also be bad news for online brokers, since they are so dependent on the health of the broader market for their revenue.

    The industry is already reeling now that Charles Schwab (SCHW), TD Ameritrade (AMTD), E-Trade (ETFC) and Interactive Brokers (IBKR) have all slashed commissions for stock and ETF trading to zero.

      The last thing that this group needs is further pressure on their bottom line due to lower interest rates.

      So unless things get really bad for the broader economy, the Fed will likely resist the calls from Trump and the bond market to go back to zero or experiment with negative rates.


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