Are You Prepared For Negative Interest Rates?

By:Tim Begany of Street Authority

Last Tuesday, all eyes were on Federal Reserve Chief Janet Yellen. In prepared testimony, she offered a few hints that interest rate increases may begin this summer.

While the crowd is thinking about rate hikes, few are thinking about U.S. interest rates heading lower, or possibly even turning negative.

The idea may seem absurd, but is it?

The notion of negative interest rates is surely controversial. Some analysts think the Fed would never let it happen, as the massive U.S. money market system would be unable to function efficiently and profitably in a negative rate environment.

Then there's the relative strength of the U.S. economy, which is seemingly strong enough to counter the need for more aggressive Fed actions. An alternative view: recessionary pressures from the soaring dollar and weak foreign economies could eventually prove powerful enough to force the Fed into more rate cuts.

Thanks to decade-high strength, the dollar is squeezing U.S. multinational firms as profits earned in weaker foreign currencies are worth substantially less in dollars. Thus, analysts see U.S. corporate profits only growing about 7% overall this earnings season, down from the 11% gain projected a few months ago. The strong dollar is expected to contribute to a 2% drop in earnings in the first quarter of this year (on a year-over year basis), compared with the 9% growth analysts were forecasting in December.

Even without excessive dollar strength, the United States could still face especially stiff economic headwinds from Europe and Japan, where central banks and governments are desperately trying to jumpstart economies teetering on the edge of recession. Slumping foreign economies might drag down the U.S. economy, as many of our firms conduct a lot of business in those regions (SP 500 firms generate nearly half of revenue internationally, mainly in Europe and Asia).

Either way, any hint of recession in the United States could easily prompt widespread calls for the Fed to cut interest rates to forestall a slowdown.

After more than six years of loose monetary policy, it wouldn't take much to induce negative interest rates here. Indeed, the Fed funds rate sits at just 12 basis points.

Yet even if the Fed itself never adopts a negative-rate policy, market forces could easily trigger below-zero yields on some types of debt, particularly shorter-term issues, which currently offer virtually zero yield. The yields on three- and six-month Treasuries, for example, are currently 0% and 0.04%, respectively. Even two-year Treasuries are only returning 61 basis points a year.

There's a similar situation in government agency debt and the highest-quality corporate bonds. For those with one-year maturities, yields are typically in the range of 40 basis points. When I was managing portfolios during the early days of the recession, you could still get one-year agency and AAA-rated corporate bonds yielding around 10 times as much.

These days, yields on these sorts of bonds could easily go negative if buyers are willing to pay high enough prices for them. A potential catalyst for this could be even slimmer yields in Europe and Japan, where many investors have already shown some willingness to accept negative yields on some of those regions' safest bonds.

According to a recent Wall Street Journal article, "yields on Belgian, French, Dutch, Swedish, Austrian, Finnish, Danish and German government bonds are negative for maturities from four to six years. In Switzerland's case, they're negative to an eye-watering 13 years."

In Germany, Europe's largest and strongest economy, government debt yields are negative on maturities out to five years, with that country's five-year bond currently yielding -0.08%.

Last year in Japan, yields on sovereign debt securities maturing in under three years briefly went negative. Now, Japanese bond returns are barely above zero out to five years. Even 15-year Japanese government bonds yield just 0.76%.

Such abysmal returns have foreign investors piling into high-quality U.S. bonds, which are still relatively attractive. The three-year Treasury, for example, now has about a 1% yield.

Looking ahead, U.S. bonds could be even more popular among foreigners as renewed stimulus further suppresses interest rates overseas -- especially in Europe, where the region's central bank will soon be unleashing a mammoth bond-buying program. In tandem, the central banks of several European countries (Denmark, Sweden and Switzerland) are keeping their equivalent of the Fed funds rate below zero to help support economic growth.

Such developments raise the prospects for higher bond prices and, in turn, lower yields in the United States

Risks To Consider: As an upside risk, stimulus efforts in Europe and other regions may, in time, prove effective. This could help to elevate the U.S. economy, reducing the likelihood of further Fed rate cuts.

Action To Take -- As low as they are, U.S. interest rates could still fall substantially further under current economic circumstances. While a negative-rate policy by the Fed is doubtful, negative yields could pop up in the types of shorter-term U.S. bonds I've mentioned. Income investors may have little choice but to take more credit risk and/or go out farther on the yield curve to get a decent return.

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