Negative interest rates may seem about as far-fetched as it gets for the U.S. economy, but…maybe not? In an official Federal Reserve news release on January 28, Janet Yellen alerted banks to prepare for that very possibility.

Don’t hold your breath however – in our view, it is highly unlikely that the U.S. would end up resorting to such an action. In theory, implementing negative interest rates are intended to encourage big banks to utilize idle cash reserves for lending and credit which, in turn, could lead to more fixed private investment and consumer spending to fuel economic activity and demand (as well as stoke inflation).

But, big banks don’t respond well to having their hands forced and would probably be more likely to hoard that cash or look to diversify into more risk assets, like foreign bonds. What banks want is a steep yield curve where fed funds rate borrowing is cheap and the 10-year Treasury trades at a premium. The Fed could actually, arguably, be selling bonds (to put downward pressure on price and upward pressure on yield) to accomplish that.

But, back to the notion of negative interest rates. While unlikely, what Yellen really wants is for banks to test their balance sheets and operations to see how they can, and would, cope with negative interest rates. Part of the Dodd-Frank Act requires the biggest banks to perform stress tests and, for the first time ever in 2016, the Fed’s annual stress test will embrace a scenario where the interest rate on the three-month U.S. Treasury becomes, hypothetically, negative in Q2 of this year. The Fed has defended this move by saying that, in the event traditional policy measures cannot keep the world’s biggest economy afloat during a financial crisis, this new policy move would give them another option to explore.

Bottom Line for Investors

The effectiveness of slightly negative interest rates is far from assured and experiments thus far in countries like Finland and Sweden haven’t delivered conclusive results. It probably wouldn’t matter anyway, as those countries bear virtually no resemblance to the complexities of the U.S. economy.

By and large, it is our view that negative interest rates are not only unnecessary to stimulate the U.S. economy (it’s growing just fine without them), they’re also undesirable. Markets would likely look upon them as a move of desperation and banks don’t want to feel trapped into lending. If more lending and better credit conditions are what the Fed and politicians want, they’ll probably have to resort to policy actions that are not popular in the current environment following the financial crisis. They’d have to create an environment where banks want to take more risk, meaning a reduction in some of the regulations associated with Dodd-Frank. Don’t count on that anytime soon.


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