The Mechanics Of NIRP: How The Fed Will Bring Negative Rates To The U.S.

Over one year ago, when the "conventional wisdom" punditry was dreaming up scenarios in which the Fed could somehow hike rates to 3% and in some magical world where cause and effect are flipped, push the economy to grow at a comparable rate we said that not only is the Fed's tightening plan going to be aborted as it represents "policy error" and tightening in the middle of a global recession, but it will result in the Fed ultimately cutting rates back to zero and then, to negative.

Gradually the market is agreeing with us, and as the following chart shows, the probability of a negative 3 month Libor rate in 2 years has risen to 10%.

It is also why, as we showed earlier, the bets on NIRP within two years have spiked in recent months, in what is the "shadow market crash" trade du jour.

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So now that talking about NIRP in the US is no longer anathema but a matter of survival for market participants for whom frontrunning the Fed's policy failure has emerged as a prerequisite trade, the question is: what are the mechanics of NIRP, what are the implications of negative rates for US markets.

Here is the handy answer courtesy of Bank of America's Marc Cabana

Mechanics of negative rates

Negative interest rates have generally been employed after a central bank has already lowered their deposit rate to zero and they either desire to (1) further ease monetary policy to fight the growing threat of deflation, i.e. ECB, BoJ, Riksbank policies, and / or (2) reduce capital inflows that were resulting in undesired currency strength, i.e. SNB and DNB policies.

To implement negative rates, central banks set their “deposit rate” or rate at which banks can deposit funds with monetary authority at a negative level. This results in banks paying a fee for holding their reserves with the central bank. Most countries that have adopted negative rates do not apply them to required reserves but only apply them to all or some of the deposits at the central bank, Table 1.

So why don’t banks holding excess reserves just move them off of their balance sheet via lending or asset purchases to avoid the fee? Recall, monetary policy generally runs through a closed system and the central bank is the only entity that can permanently change the amount of reserves outstanding. Funds loaned by one bank or used to purchase securities will eventually end up re-deposited at another, which means that reserves can only be re-allocated within the system but not independently withdrawn from it. Banks could convert their excess reserves to cash but storage costs generally make this unattractive unless rates are deeply negative.

Taking rates negative in the US

To implement negative interest rates in the US, the Fed could utilize the overnight reverse repo facility (ON RRP) and interest rate on reserves. These tools could potentially shift the fed funds effective into negative territory, though the amount of negative fed funds trading would likely depend on the cost of holding reserves.

ON RRP: If the Fed desired to take rates negative they could set the ON RRP rate below zero or temporarily suspend the facility. Setting the ON RRP rate below zero would lower the "soft floor" it establishes on interest rates and likely shift lower levels on other money market instruments. It is also possible that the Fed could temporarily suspend the ON RRP facility, which would move money market rates lower as money funds and GSEs would no longer have a backstop investment option at the Fed. We guess that the Fed would maintain the ON RRP facility in a negative rate environment since they would likely view any period of negative rates as temporary and set the ON RRP rate at 20 to 25 basis points below IOER. Note that the Fed did not see the existence of the ON RRP and the temporary reserve draining that it provides as contradicting prior periods of expansionary monetary policy accommodation, Chart 2 (the ON RRP was used for “testing” purposes at that time).

Interest on reserves: The Fed could also lower the interest rate on required (IORR) and excess reserves (IOER) to below zero. The Board could choose to move these rates below zero in tandem or move them in an asymmetric manner. For example, the Board could keep the IORR rate at zero in order to avoid an explicit tax on required bank reserve holdings while moving the IOER rate to a negative level. This is the case in Europe, where required reserves are remunerated at the MRO rate of +5 basis points, with reserve holdings in excess of required subject to the -30 basis point rate.

In all likelihood, the Fed would only take the IOER rate negative and leave the IORR rate at zero. If the Fed were to adopt such an approach before it begins the process of winding down its balance sheet, it would be subjecting nearly $2.3 trillion in excess reserves to negative rates, Chart 3. Assuming the Fed took the IOER rate to negative 10 basis points, this would result in an annual cost to those holding excess reserves of nearly $2.3 billion. In order to limit the costs, the Fed could consider exempting a certain amount of excess reserves by institution similar to the policies of the BoJ, SNB, and Danish central bank. However, negative interest rates would be yet another cost to holding reserves in addition to the FDIC assessment fee for domestic banks and SLR for large banks.

Fed funds target: The Fed could also work to set a target range for the fed funds effective below zero. At present, fed funds trading is driven largely by Federal Home Loan Bank (FHLB) lending as they seek to earn a higher rate on their cash versus what can be provided on overnight deposit with banks, in the ON RRP, or in their non-interest bearing account at the Fed. In a negative rate environment, FHLB activity in the fed funds market would likely depend on the cost of keeping funds with banks or at the Fed. If banks or the Fed charged FHLBs on their account holdings, the FHLBs might still be willing to lend funds at rates where other banks would find it profitable to engage in fed funds – IOER arbitrage, even at negative rates. However, if banks or the Fed did not pass along such charges, there would be little incentive for the FHLBs to sell funds below zero and volumes would decline from their already low level of around $50 billion per day.

What are the Implications of negative rates

Negative rates would shift the structure of interest rates lower which should theoretically be stimulative by lowering borrowing costs. In the US, we would expect Treasury bills to trade at negative levels and for rates on other money market instruments to decline. Negative rates have indeed been effective at shifting broader interest rates lower, with yields on German and Japanese sovereign debt trading negative out the 7 year tenor and Swiss government debt trading negative out to 15 years. While it is difficult to separate the effects of negative interest rates from increased forward guidance or asset purchase expectations, negative rates are effective at removing a lower bound that investors may have once believed to be a floor.

Despite the declines in interest rates, our European colleagues have found mixed evidence of the negative rate impact on lending conditions. Their findings suggest that banks may try to offset the negative deposit rate impact on their profitability by raising loan borrowing costs.

Negative rates also weaken the domestic currency which should be stimulative for the export sector. There is clearer evidence that negative rates serve to weaken domestic exchange rates when they are applied to stimulate growth and boost inflation, as in the case of the BoJ, ECB, and Riksbank,Table 2. Foreign exchange rates are inherently relative so if the US were to move rates into negative territory it would likely cause the dollar to weaken, though this might only be temporary if other central banks responded by further lowering their policy rates below zero.

Negative rates would likely hurt bank profitability given an increased pressure on net interest margins. Assuming the Fed does not cut rates this year, US banks are expected to benefit from over $12 billion in interest on reserves payments. In a negative rate environment, banks would be reverting payments to Federal Reserve and they also might be reluctant to pass negative borrowing costs along to their retail depositors. Additionally, there is no guarantee that banks would increase lending given lower spreads across its loans. Charges or fees on smaller retail depositors would likely be avoided for as long as possible, though it may be difficult to avoid explicit deposit charges depending on the extent of negative rates. In Europe, many banks have applied fees for large corporate account deposits and some have also extended fees to retail deposits, especially where rates are more deeply negative, such as Switzerland and Denmark.

Negative rate complications in the US

Negative rates would present a variety of challenges in the US, especially for the functioning of money markets and money market mutual funds. The US Treasury would also likely need to adjust their auction systems to allow for bill and nominal coupon offerings to close above par. There could also be shifts in savings and payment behavior to avoid potential costs from negative rates.

Money markets and implications for money funds

Federal Reserve officials have often noted concerns over money market functioning when discussing negative rates. However, the Fed’s thinking on this issue has likely shifted over recent years as negative rates abroad have generally not been associated with broad strains in money market functioning. The Fed has also questioned whether the infrastructure underlying securities transactions in the US could readily adapt to negative interest rates in trading, settlement, and clearing systems. We believe that the Fed will work with industry participants to address some of these technical issues before taking rates negative, though they would probably like to see rates higher before seriously engaging in these discussions to avoid signals about near term policy.

Another complication of negative rates is the $3 trillion money fund industry and its ability to operate in such an environment. Money funds struggled to offer low positive yields over recent years and cut their fees in order to retain business amidst low frontend rates, Chart 4 & Chart 5. Should money market rates decline further, it is likely that the majority of money funds would be challenged to generate positive returns even if weighted average maturities or lives were extended to their full 60 or 120 day maximums. To deal with low returns, money funds could consider charging customers, reducing management fees, seeking subsidies from fund sponsors, or closing their doors.

Negative rate impacts on money fund asset totals would likely depend on what alternative investment options were yielding. Investors in government money market funds would likely only consider withdrawing their funds only after comparing money fund rates to other alternatives, such as bank deposits or negative yielding Treasury bills. Similarly, investors in prime funds might compare the liquidity and convenience of money funds to what could be provided by investing directly in low-yielding CD or commercial paper markets.

Although negative rates have posed challenges for the $1.15 trillion (€1.04 trillion) in European money funds, the industry has adapted. European money fund assets have increased since the fourth quarter of 2013 even as ECB deposit rates went negative, Chart 6. European money funds have responded to the challenging rate environment by taking their yields negative. In January, the Institutional Money Market Fund Association euro prime and government money fund 7-day averages yielded negative 17 and negative 43 basis points, respectively. To apply this, some European money funds employ "reverse stock splits" or "reverse distribution mechanisms" where outstanding shares in the fund are gradually reduced to reflect the negative yield. Some European funds have also applied explicit customer charges as a result of negative yields. Both mechanisms allow European money funds to generate management fees while rates are negative.

US money funds might consider applying similar mechanisms in a negative rate environment. However, there would likely be numerous legal questions and substantial amendments to pre-existing fund documentation in order to apply such terms. If such changes were not possible, money funds might need to receive sponsor support or consider closing their doors. Any large shifts out of money funds would risk meaningful disruptions to typical intermediation channels, given that corporates and financial firms are beneficiaries of more than $1 trillion in existing prime fund investments. Any permanent shrinkage in money fund assets could also complicate the Fed’s eventual exit strategy and diminish the importance of the ON RRP facility, where money funds are the largest participants.

Negative Treasury rates and elevated auction demand

Negative Fed policy rates would place further downward pressure on Treasury yields, increase the scope of issues trading below zero, and likely necessitate changes to US Treasury Department auction systems to allow bill and nominal coupon offerings to close above par. Treasury auction rules do not allow for issuance of bills or nominal coupons at negative rates. According to current rules, in the event that bills or nominal coupons are auctioned at par, auction participants are awarded a pro-rata share of their bid amount for the issue. This results in elevated bid-to-cover ratios when issues are expected to trade negative in the secondary market, as auction participants are incented to overbid, expecting that their ultimate allocation will be pared back, Chart 7. Current auction rules effectively amount to a subsidy for auction participants when issues are trading at negative rates, since auction participants pay the Treasury par but can then quickly sell in the secondary market at a premium. Should the Fed adopt a negative rate policy, we expect that Treasury would work to quickly update its auction systems to capture this implicit subsidy.

Note that similar auction issues do not apply to all Treasury securities, as TIPS can be issued at a negative yield while floating rate notes (FRN) can be auctioned with negative discount margins and issued at a premium. Since TIPS and FRNs have floors on the indexed or floating-rate portion of their issues, investors will not be required to make periodic payments to Treasury during periods of deflation or with negative bill rates.

Shifts in systems and payment behaviors

New York Fed researchers have written about shifts in savings and payment behavior to avoid potential costs from deeply negative rates. Should rates move substantially below zero and banks begin to charge depositors, it is possible that cash vault holdings would increase or that special banks could be formed to store physical currency. Consumers and businesses might also seek to pre-pay credit card, account payable, or tax bills in order to reduce their cash holdings. Similarly, those who are expecting payments from creditworthy entities might prefer to defer them while those receiving checks might wait longer periods before depositing them. We do not expect the Fed would find such behavioral shifts particularly productive and might view them as an additional cost to negative interest rates. However, these behavioral shifts have yet to meaningfully manifest themselves in Europe and it may require an environment of more deeply negative interest rates before they emerge.