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The probability of negative U.S. rates is on the rise

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(Bloomberg) — Global central banks have opened the door to negative U.S. interest rates, in Wall Street’s view.

After the Bank of Japan cut some rates below zero last month to spur growth and inflation, strategists are weighing the Federal Reserve’s options in case of a crisis. If the world’s biggest economy weakens enough that traditional policy measures don’t help, the Fed may consider pushing rates below zero, according to Bank of America Corp. and JPMorgan Chase & Co.

That step would broaden the Fed’s toolkit beyond what was available during the financial crisis, when it slashed its overnight benchmark near zero and bought bonds to stimulate the economy. In 2012, New York Fed researchers said negative rates could prompt individuals to avoid depositing money in banks, potentially weakening the financial system.

“They’re still concerned, but not as much as they once were,” said Mark Cabana, a New York-based interest-rate strategist at Bank of America. “They’ve seen how successful they were in other countries, where there haven’t been adverse impacts on market functioning.”

Traders may be getting on board with the possibility too. The implied probability of U.S. rates sinking below zero by the end of 2017 has jumped to roughly 13 percent, the highest since at least July, data compiled by Bloomberg show. The wagers are tied to the London interbank offered rate, which partly reflects expectations for Fed rates.

Uncharted territory

Michael Feroli, JPMorgan’s chief U.S. economist in New York, wrote in a note last week that the Fed may consider negative rates because the five central banks that have done so — in Denmark, the euro region, Japan, Sweden and Switzerland — haven’t faced hoarding of cash by individuals or financial- market disruption. Those were among the risks the New York Fed analysts warned about.

“Back in 2012, it was relatively uncharted territory, and there was still a lot of reluctance from major central banks to consider negative rates,” said Cabana, who was a trader and analyst at the New York Fed from 2007 to 2015. But now, “it’s somewhat natural to ask about when the Fed would consider negative rates, and what the implications would be.”

Fed officials have said negative rates are possible, though not probable any time soon. Fed Chair Janet Yellen said in September that negative rates weren’t a main policy option, but that officials would evaluate the approach if needed.

Practical implications

“It’s working more than I can say that I expected in 2012,” Fed Vice Chairman Stanley Fischer said in response to a question after a speech last week. As a “practical policy, you have got to do a heck of a lot of work,” he added.

Both analysts said the money-fund industry would need to adapt to negative rates. The Fed would also have to ensure the policy didn’t put too much stress on the banks, which would face a cost for holding reserves with the central bank. It would also require a revamp of Treasury auction rules, Cabana said.

There may also be political implications. Negative rates have had an especially strong influence on exchange rates, according to Feroli, and a weaker dollar may pressure other regions’ exports.

“The leadership role of the Federal Reserve in the global monetary system may lead to some hesitancy to engage in what may be uncomfortably close to a skirmish in the currency wars,” he wrote.

Economic resilience

Fed officials say the question of negative rates won’t arise unless the U.S. looks like it’s in a recession, which they don’t anticipate. A report Friday showing stronger-than-expected wage growth quieted some concern over a possible economic slowdown. Ten-year yields touched the lowest in a year Monday as investors sought a haven from tumbling stocks.

“Until we see further evidence to the contrary, my expectation is that the U.S. economy will work through the latest episode of market turbulence and soft patch to regain its footing for moderate growth,” Cleveland Fed President Loretta Mester said in a speech last week.

Traders aren’t ruling out a contraction, and have bet on a slower pace of rate increases.

Futures don’t fully reflect another quarter-point Fed increase until late-2017. At the end of 2015, traders were betting on a hike by July 2016. Traders see just a 30 percent chance of a boost by the end of this year, according to data compiled by Bloomberg.

Yet if the economy does teeter into recession, global central banks have given the Fed a blueprint for a new approach.

“The absence of major snafus overseas may have made” negative rates “a more attractive ‘in case of emergency break glass’ option for the Fed,” Feroli wrote.

– With assistance from Alexandra Harris, Liz Capo McCormick and Matthew Boesler.

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