Seven weeks after the first federal funds interest rate reduction in a decade, the Federal Reserve reduced interest again. On Sept. 18, the Fed announced it would reduce interest rates by another 0.25% to settle at a range of 1.75%-2%. This latest reduction occurred just one week after the European Central Bank reduced its deposit rate by a tenth of a point to -0.5%.
What are the implications for low and even negative interest rates, globally and domestically?
The European Central Bank reduced its deposit rate to a negative level in June 2014. Negative rates essentially penalize banks for keeping excess money on deposit with the central bank instead of lending it out. The general theory is that negative rates will incentivize banks to issue more loans to spark business investment, thereby producing growth in the economy.
Negative interest rates can be passed on to bank customers. Depositors could be charged for keeping money in banks and borrowers could be paid to borrow money. It’s quite the paradox to traditional banking.
In fact, in August, a Danish bank offered a 10-year mortgage at -0.5%. Yes, the bank is actually paying their clients to take out mortgages. Oddly, this happens to be a better deal for the bank than the alternative. With the central bank of Denmark creating a negative deposit rate of -0.75%, this bank is actually coming out ahead by losing less.
Although interest rates are low by historical standards, rates in the U.S. are much higher than other developed economies. Note that short-term interest rates are higher than some longer-term interest rates. This phenomena is referred to as an “inversion of the yield curve” and has historically been a precursor to a recession - not the cause, per se, but an indicator of underlying economic weakness. However, the time lags between a yield curve inversion and subsequent recessions vary widely, ranging from seven to 19 months.
A yield curve inversion is caused by investors buying up longer-term bonds in fear of slower growth ahead. When the prices of bonds rise, corresponding yields fall. This market-driven effect lowers interest rates on the long end of the curve to a point below the short-end rate, which is influenced by the central bank.
Higher U.S. interest rates have resulted in a greater demand for U.S. bonds. Investors must have U.S. dollars to buy U.S. bonds. As such, if foreign investors desire to purchase U.S. bonds, they need to exchange their foreign currency for dollars.
This demand for U.S. dollars makes them scarcer and, therefore, puts upward price pressure on the dollar. The sale of the foreign investor’s home currency results in an oversupply on the market and weakens it against the U.S. dollar. This, however, is only one dynamic that has been contributing to a strong U.S. dollar and lower interest rates.
As long as the U.S. offers attractive interest rates and the U.S. economy is otherwise stable and/or growing moderately, the demand for U.S. bonds and the U.S. dollar is not likely to subside.
Now, with two Fed interest rate cuts, the U.S. dollar has continued to strengthen in 2019. Demand for U.S. bonds has driven yields lower to levels not seen since 2016. If major global central banks continue to reduce interest rates to generate economic growth, interest rates likely will remain low across the globe for the foreseeable future. In fact, former Federal Reserve Chair Alan Greenspan indicated that it is “only a matter of time” before the U.S. experiences negative interest rates.
Whether or not Mr. Greenspan is correct, in the near term, the U.S. government is considering taking advantage of these low interest rates by issuing a 50-year treasury bond, which could make its debut in 2020. Refinancing some of the $22 trillion national debt at these low interest rates for an extended time frame is an attractive proposition. Given the global interest rate backdrop, demand for the bond could be strong. Moreover, given slower global growth and geopolitical uncertainty, the overall interest rate trends will seemingly remain lower for longer.
Andy Drennen, certified financial planner, is a vice president and portfolio manager at Central Trust Co. He can be reached at email@example.com.
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