Although negative rates aren’t officially here, they’re here in reality due to Treasury yields falling below inflation. That means investors might want to consider how to position their portfolios, no matter what the Fed ultimately decides.
They haven’t really worked in Europe, and the Fed writes off the very idea. Still, negative interest rates are already with us in the U.S. and have been for a while, thanks in part to COVID-19.
Wait a minute. How can we say negative rates exist when the Fed’s target rate remains positive at between zero and 0.25%? It’s actually a relatively simple calculation, and investors should consider how to position themselves for this strange environment that seems likely to stick around as COVID-19 takes its grim toll. Negative rates are a fact on the ground whether or not the Fed actually takes the plunge and makes it official.
Here’s why rates are negative: The 10-year Treasury note yielded approximately 0.8% as of late October 2020. That’s well below the latest year-over-year core consumer price index (CPI) growth of 1.7%, giving us a “real yield” of negative 0.9%.
You get that by subtracting inflation from nominal returns on investment. An investor putting money into a 10-year Treasury note with those yield and inflation numbers factored in would end up losing ground after a year. That’s despite the Treasury yield being above zero and the Fed sticking to its guns by not dropping its overnight lending rate below zero.
“We’ve been in a quasi-negative rate environment for a while,” said Shawn Cruz, trader business strategy manager at TD Ameritrade.
The Fed contributes to that even without officially taking rates below zero. Just by lowering them to current levels, it made it harder for investors to break even. So how should investors approach this scenario?
Whether negative rates result from direct central bank action or a combination of things, sectors that tend to do better in times of strong growth might not do as well with rates of zero or below. We’re talking about Financials and Industrials. Instead, negative rates might favor things that you can put a fence around, lock up in a safe deposit box, or invest in without much expectation of huge future growth beyond dividends.
“Negative rates would likely be favorable to the real assets, like commodities and real estate, and would potentially help some Material sector stocks as well,” Cruz said. “It would not be beneficial to the Financial sector.”
“All your ‘safe-haven’ assets like Treasuries have little-to-no yield” in a negative interest rate situation, Cruz continued. “Even investment-grade corporates would have little-to-no yield. Your high-yielding credit would be pretty risky, so people would go into lower-risk equities, including traditional lower-risk stocks like Utilities and more defensive stocks like Consumer Staples.”
By “high yielding,” Cruz was referring to corporate bonds that pay heftier yields but come with more risk. They’re not for everyone, so anyone looking for yield in a negative rate environment might start considering defensive stock sectors or longer-term fixed income. It looks like this is already happening. The high-yielding Utilities sector led all S&P 500 sectors in October by a pretty good length.
In Europe and Japan, the central banks officially set benchmark interest rates at negative levels along some points of the yield curve. The Fed Funds rate target was set between zero and 0.25% when the pandemic first slammed markets. That’s down sharply from recent peaks above 2% just two years ago.
While “defensive” and dividend-yielding sectors of the stock market have performed well during the current negative real rate environment, the pandemic’s twisted things a little. Info Tech and Communication Services—dominated by “mega-caps” including Apple (AAPL), Amazon (AMZN), Microsoft (MSFT)—have been among the top market performers of 2020. That’s less rate-related and more a function of investors believing these companies benefit from the “stay at home” scenario so many are stuck in.
We’re getting ahead of ourselves, however. What is a negative interest rate policy (NIRP), why do central banks sometimes put it in place, and would the Fed ever consider such a move?
When rates go negative, it means that banks depositing money into the central bank must pay to keep the money there. Theoretically, this would make banks more willing to make loans to businesses and keep money flowing into the economy, rather than sitting in a vault. NIRP is also designed to stoke inflation to help economies avoid entering dangerous deflationary spirals.
The U.S. never targeted negative rates, but the Fed did keep its benchmark short-term interest rate at approximately zero from late 2008 through late 2015 as the economy got hit by the Great Recession and its aftermath. As we noted, the Fed dropped rates back to that level in March. Would the Fed ever resort to negative rates?
Cruz doesn’t think so, but he can’t write it off, either, based on how COVID-19 has torn through the economy. It gets even more complicated now as chances of a fiscal stimulus seem to fade.
“The big thing that’s changed regarding negative rates is that it used to be more of a thought exercise, but now it seems more plausible,” Cruz said. “We’re within a stone’s throw of effectively being there with all the moves the Fed’s been making.”
The Fed lowered rates as far as it could in 2020 without taking them actually below zero, and it also did other things like ramping up asset purchases. That means venturing into the market and scooping up mortgage-based securities and Treasuries to add capital and liquidity. This is called “quantitative easing.”
If the Fed thinks its current policy hasn’t worked, it has options besides dropping rates below zero. It could add to its asset purchases. It could also continue lobbying Congress for new fiscal stimulus as Fed Chairman Jerome Powell did for months in 2020. That mostly fell on deaf ears after Congress passed a large fiscal stimulus bill early in the pandemic crisis.
Assuming fiscal stimulus has to wait until 2021, as appears more likely, does that mean the Fed could decide to cut rates to below zero? Its late 2020 meetings might provide more insight, so investors should consider paying close attention to Powell’s post-meeting press conferences and to Fed meeting minutes, typically released several weeks after each meeting.
“If they do cut further, the question becomes, is the juice worth the squeeze?” Cruz said. “Negative rates haven’t helped Europe much, and the Fed looked at that and decided that corporate bond buying was more effective than cutting to negative territory. Also, pretty much across the board, Fed members have come out and said we need more fiscal stimulus.”
In late 2019, former Fed Chairman Alan Greenspan expressed the belief that eventually negative rates could happen here.
When Greenspan spoke in late 2019 of the immense appetite investors seem to have for yield, he noted that by purchasing Treasuries for that yield, investors effectively lower the yield they receive because yields fall when the underlying Treasury price rises.
“We’re so used to the idea that we don’t have negative interest rates, but if you get a significant change in the attitude of the population, they look for coupon,” Greenspan told CNBC.
Europe and Japan put negative rates in place to stimulate business and consumer spending, but arguably the strategy didn’t work. By 2019, close to $17 trillion in negative-yielding bonds had built up around the world with little or no sign of improvement in the tepid European and Japanese economies. And that was before COVID-19.
Economic growth in the Euro area, as measured by gross domestic product (GDP), rose just 1.3% in 2019, according to The World Bank, and that was with negative interest rates greasing the skids and no pandemic. COVID-19 makes it a little harder to judge the impact of negative rates, because it’s likely no amount of rate easing would blunt the impact of the shutdowns. Still, Q2 2020 GDP growth in the Euro area looked dismal at a negative 11.8%.
Things don’t look any better in Japan. Growth was 0.7% in 2019, before the pandemic, The World Bank said. That’s not significantly better than Japan’s 0.4% growth in 2014 when rates were positive.
“In talking about negative rates, we’re finding that all these countries tried, but no one has really been able to boost business spending,” said Sam Stovall, chief investment strategist at research firm CFRA. “A lot of people question the merit of negative interest rate policies, so why would we want to here when it hasn’t worked?”
In the U.S., the Fed kept up its drumbeat against negative rates even as 2020 advanced and the economy fell more than 31% on a seasonally adjusted basis in Q2 before rebounding 33.1% in Q3. GDP remains more than 3% below the level of Q4 2019.
“Negative rates are not a tool that we see as something we’re looking to use,” Powell told Bloomberg in early October 2020. “It’s really two things. One is that we have tools we think served us well and will continue to serve us well. And the second is the evidence on negative rates is sort of mixed.” Since their effect isn’t clear and the Fed now has a better understanding of how asset purchases work, he feels the Fed has the tools it needs.
Desperate times can mean desperate measures, however, and if the pandemic intensifies, perhaps the Fed might be tempted to play the negative rate card. At the very least, the benchmark 10-year Treasury yield could conceivably re-test recent record lows down near 0.5%. That would intensify the negative rates on the ground situation investors find themselves in and could hasten the flow of money into those safety deposit box-types of investments Cruz referred to.
The low rate situation also wreaks havoc on the U.S. dollar, which in October fell to 2.5-year lows. A weak dollar can actually help U.S. companies by making their products cheaper overseas, but can exacerbate problems back home. Mainly, it’s inflationary. While the Fed wants to bring inflation back and avoid a deflationary spiral like in Europe and Japan, it also has to be cognizant of price pressure on consumers in a country where unemployment is near 8%. That puts the Fed between a rock and a hard place.
Assuming rates here fall to zero or below, how should investors consider reacting? Utilities, Real Estate, Consumer Staples, and other dividend-paying stocks could come into play.
These sectors offer yields well above the 10-year Treasury yield. In fact, the dividend yield on the S&P 500 Index (SPX) of 1.75% as of late October 2020 was higher than the yield on the 10-year Treasury note and the 30-year bond. The Utilities sector rose 10% to lead all sectors in the late-September through late-October period as investors chased yields. But it’s worth noting that dividends are never a guarantee, and can be particularly vulnerable during a recession. Companies have already been cutting them left and right since the pandemic hit. They’re often the first place where companies try to trim costs.
One sector that investors might want to consider being cautious about in such a scenario is Financials. “Financials is the sector that will get hurt more than anyone else by negative interest rates,” Cruz said. “Lower rates don’t bode well” for Financial stocks.
Already, Financials are the second-worst performing S&P 500 sector year-to-date in 2020, down more than 21%. Negative rates can hurt banks because they have to pay to leave money on deposit at the central bank and can end up paying to own government bonds. At the same time, they often can’t pass negative rates along to retail depositors because they fear the money will go away.
In a negative interest rate environment, Cruz said, it could be tempting to chase high-yield fixed income investments, as those types of investments might be among the only ones paying relatively high rates. But investors need to know what they’re getting into before adopting such a strategy.
“The biggest thing is, you have to be careful not to chase yield into risky places,” Cruz said. “People will look at the bond market and say, ‘Here’s a good yield.’ And if you’re at negative rates and something looks good from a rate perspective, it’s probably very risky. Really ask yourself: why is this paying such a high yield relative to lower risk assets?”
In other words, when the weather gets rough, many investors look for a place to park, which brings us back full circle. Even a zero—or negative—interest rate on Treasuries and other investments may seem compelling, if the economic situation were to deteriorate. It’s an old Wall Street adage: “Sometimes you seek return on invested capital; other times the overriding concern is the return of invested capital.
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