On 23 May 2020, The Economist published an article with the title, Should the Fed cut rates below zero?1 This piece underscores the policy debate across many countries that has garnered attention since the start of the COVID-19 crisis. Given the unprecedented nature of this medical and economic crisis and the uncertainty ahead, with the target Fed Funds range at 0-0.25% and the Bank of England base rate at 0.10%, many ask whether the Federal Reserve / Bank of England would adopt a Negative Interest Rate Policy (NIRP). As this is a question that has come up frequently in recent conversations with our clients, we wanted to provide a thorough overview of the topic and considerations for CRE investors.
A negative bond yield occurs when the bond price trades at such a premium that the buyer is effectively paying the bond issuer for the right to own the bond. Said another way, the buyer paid such a price that if they were to hold the bond to maturity, they would receive less money back at maturity. To my knowledge, no central bank has made negative long-term yields a policy target, though central banks have used forward guidance to influence longer-term yields, while the Bank of Japan committed in 2016 to the 10-year Japanese government bond yield at 0% and the Reserve Bank of Australia recently set a target yield of 0.25% on 3-year Australian Government bonds.
NIRP occurs when a central bank intentionally takes its short-term policy rate below 0%, making negative short-term rates a monetary policy objective. This means banks are required to pay interest for holding excess reserves with the central bank. (Back to top)
One argument is that there is no significant discontinuation between a zero or near-zero policy rate and a marginally negative policy. This was Bernanke’s sentiment in a 2016 Brookings blog2: “Logically, when short-term rates have been cut to zero, modestly negative rates seem a natural continuation; there is no clear discontinuity in the economic and financial effects of, say, a 0.1 percent interest rate and a -0.1 percent rate.” It is important to stress that economists think in terms of real rates (i.e., nominal rates adjusted for inflation). It is real rates that influence economic behavior. When inflation is low and the policy rate is at or near zero, central banks can reduce the real policy rate further by taking the policy rate into negative territory. And if inflation (or inflation expectations) were to fall, then the real policy rate would increase and that could make it more compelling to take the policy rate into negative territory.
NIRP can be expected to operate more or less through the same channels as conventional monetary policy and generate an additional stimulus to the economy. Private consumption may increase further due to cheaper borrowing, reduced preference to save, and higher asset values. Lower cost of capital may motivate companies to approve more investment projects. The signal that a central bank will do whatever it takes to aid the economy may further stabilize economic activity. Banks may be nudged to hold less reserves and lend more. Fall in asset values and rise in non-performing loans tend to cause banks to deleverage and pull back credit, so further asset reflation through negative rates may arrest these dynamics. One interesting difference from conventional zero-bound monetary policy is that NIRP effectively conveys to market participants that even the longer-ends of the yield curve can turn negative, thereby allowing monetary easing to propagate through the entire yield curve.3
Kenneth Rogoff, Thomas D. Cabot Professor at Harvard University and Chief Economist at the IMF from 2001-03, made a case on 4 May 2020 for “deeply negative interest rates”4 — far more than what European and Japanese central banks have undertaken.
Rogoff believes that the central limitation to NIRP, namely the potential large-scale hoarding of cash when rates become negative or too negative, can be addressed. He and many others have proposed solutions, such as phasing out large-denomination banknotes or eliminating cash altogether. There is a related point: bank profitability will suffer if they cannot pass negative rates to depositors. But this has proved to be less of an issue. Altavilla et al found that sound banks in the EU pass on negative rates to their corporate depositors without a contraction in funding, and that the degree of pass-through becomes stronger as policy rates become more negative. Firms with high cash holdings increase their investment and decrease their cash holdings to avoid the costs associated with negative rates. Hence, negative interest rate policy can provide stimulus to the economy.5 As for smaller retail and commercial depositors, if governments choose to shield them from negative deposit rates, that will not dramatically reduce the efficacy of negative rates.
Third, from the perspective of international economics, deeply negative rates in the advanced economies will be significantly beneficial to emerging economies, which have been hard hit by collapsed commodity prices, capital flight, high debt, and weak exchange rates — compounded by the fact that many are still in the early stages of the COVID-19 pandemic. (Back to top)
As mentioned above, the central limitation to NIRP is the large-scale hoarding of cash when rates become too negative. In theory, we will hold cash rather than pay interest to the banks. But since it will be inconvenient and impractical to hold large quantities of cash, we will be willing to pay for storage. In other words, we will tolerate negative rates — up to a point. A 5 August 2010 Federal Reserve memo6 estimated that the Federal Reserve cannot bring the Interest on Excess Reserves (IOER7) below -35 basis points. Interestingly, European central banks have taken policy rates below -35 basis points without triggering wide-scale currency hoarding and without causing critical disruptions to their financial systems. Nonetheless, where that tipping point lies remains a major concern.
If the Federal Reserve does not want to take policy rates below -35 basis points, we can reasonably ask, “how impactful would setting the Fed Funds rate and IOER rate at -35 basis points be?” In the 2010 memo, Burke et al assessed that negative IOER rates “are unlikely to reduce market rates dramatically more than an IOER of zero.” Bernanke thought that the benefits would be “modest”. Jobst and Lin looked at ECB’s NIRP and assessed that negative rates “have so far supported easier financial conditions and contributed to a modest expansion in credit…”8 One barrier to the efficacy of negative rates is the prevalence of floors in floating-rate loans. When interest rates are near zero or may turn negative, lenders tend to be resolute on inserting floors ranging from 0 basis points to 125 basis points. It is a reasonable response by lenders to safeguard their profitability, but the floors will block negative rates from flowing through to the borrowers. Given the modest benefits, are negative rates worth the trouble?
One major downside is the dent to bank profitability that leads banks to lend less, not more. Negative rates hurt bank profits by taxing their excess reserves and squeezing their net interest margin, the difference between what they pay to borrow and what they earn when they lend, when banks cannot, or choose not to, pass negative rates to their depositors. Heider et al observed that ECB’s NIRP “increases the funding cost of high-deposit banks, and reduces their net worth, relative to low-deposit banks… [and] leads to more risk taking and less lending by euro-area banks with greater reliance on deposit funding.” Jobst and Lin wrote, “the prospect of prolonged low policy rates has clouded the earnings outlook for most banks, suggesting that the benefits from a negative interest rate policy might diminish over time, while future lending growth may be insufficient to offset declining interest margins in some countries... Additional rate cuts could weaken the effectiveness of monetary policy if lending rates fail to adjust or customers withdraw cash from banks.”9 Central banks do not want a weaker banking sector in the middle of a crisis.
In the case of the U.S., a counterpoint is that bank funding depends substantially on wholesale funding from large institutional depositors and foreign depositors, not small retail depositors. The wholesale funding markets would presumably transact at marginally negative rates. Nonetheless, the 2010 memo notes that negative IOER rates “would likely result in dramatically reduced trading volumes in funding markets… and in further reductions in the profitability of MMFs, with an increased likelihood that some MMFs, especially Treasury-focused funds, would leave the market.” MMF refers to money market funds, which are critical intermediaries between non-bank lenders, such as large corporations with excess savings, and borrowers. MMFs are considered nearly risk-free. If negative rates cause MMFs to “break the buck”10 which occurred during the 2008-09 global financial crisis with jarring consequences, liquidity in a shadow banking system may decline and ironically cause short-term funding rates to rise. The SEC announced reforms on 23 July 2014 that require a floating NAV for institutional prime money market fund to essentially “reduce the risk of runs in money market funds” and protect investors and the financial system.11 Arguably then, the concern about MMFs has diminished somewhat. Nonetheless, the Federal Reserve remains skeptical about the impact of negative rates to the shadow banking system and the appropriateness of negative rates for the U.S. financial system.
Another powerful argument against negative rates is the impact on confidence. The case that negative rates can operate through the same channels as conventional monetary policy and produce modest economic stimulus may be underweight on the importance of behavioral psychology. Consumer spending and corporate investments depend significantly on their anticipated future. Claudio Borio, Head of the Monetary and Economic Department at the Bank of International Settlements, said that “the general public may not understand them and react badly… And negative rates may foster a sense that the economic situation is dire.”12 When Gillian Tett, a prominent Financial Times columnist, interviewed Japanese investors after the Bank of Japan announced NIRP, she found that “they seemed to be even more spooked than before, since they feared the radical experimentation suggested the BoJ knew something nasty that they did not.”13 Consequently, many central banks emphasize that there are other monetary policy tools in the toolkit in lieu of NIRP — asset purchases, forward guidance, yield curve control, etc. Further, central banks cannot be the only game in town. Fiscal policy and structural reforms play a vital role and perhaps acknowledging limits to monetary policy may nudge policymakers to action. (Back to top)
Chair Jerome Powell has reiterated on several occasions that the central bank remains averse to NIRP. On 18 May, in an interview with 60 Minutes correspondent Scott Pelley, Powell said, “I continue to think, and my colleagues on the Federal Open Market Committee continue to think, that negative interest rates is probably not an appropriate or useful policy for us here in the United States.”14
On 29 May, in an interview with Alan Blinder of Princeton University and former Vice Chair of the Federal Reserve Board of Governors, Powell provided further context: “…it has been 20 years central bankers and economists have been working on the problem of what central banks can do when they hit zero. Are they out of ammunition? The answer is no. During the global financial crisis, the Fed got to zero and we did two things: One, we effectively promised to hold our policy interest rate at zero for a long period of time. That affects short, medium, and long-term interest rates and that supports economic activity… We also bought — this was what has become known as quantitative easing — long-term Treasury securities and other fully guaranteed securities guaranteed by the U.S. government in order to lower long-term yields. Those are the two principal tools that we used during the financial crisis. We feel that we understand them. We no longer think of them as non-standard tools… some (central) banks decided in addition to that to use negative rates. We don’t think that that’s an appropriate tool here in the United States. I would say the evidence on whether it actually works is mixed. There are clearly some negative side effects… and it’s just not clear to my colleagues and me on the Federal Open Market Committee that this is a tool that would be appropriate to deploy here in the United States.”
Alan Blinder pressed Powell on why the U.S. is different from the eurozone. “One… there are many central bankers around the world who feel this way: the evidence on whether it actually helps is pretty ambiguous because… it interferes with the process of credit intermediation that banks undergo… To the extent the policy rate is negative, you are crushing down on bank margins and that makes them lend less and there are other, you know, possible negative effects there. I think the evidence is mixed… We also have institutional arrangements here that would not work with negative rates. I wouldn’t say those are the decisive things, like the money market funds industry which a lot of companies of various kinds use to fund themselves and which individuals look upon as a place to put their money.” (Back to top)
When the United Kingdom’s Treasury Select Committee asked Governor Andrew Bailey about NIRP on 20 May 2020, Governor Bailey replied15, “We do not rule things out as a matter of principle… that doesn’t mean that we rule things in either.” The Monetary Policy Committee has kept the lower bound under periodic review since the global financial crisis. “Given what we have to do in the last few weeks, it would be no surprise to learn that… we’re keeping the tools under active review in the current situation.” “We are very keen to observe and are observing how the economy responds to the cuts that we have made... bearing in mind arguments that have been made, and well-made actually, that the effects of cuts weaken as you get nearer to the zero bound and could even become counterproductive. And that’s one of the arguments that we have to assess, of course, in the context of negative rates.” “If I could draw some overall messages… one is that the context in which negative rates are used is very important. That’s the cyclical context. Secondly, the structure of the financial system in which they are done is important. Each country has a different structure… Thirdly, I think the communication of it… will be absolutely critical.” Negative policy rates are not something that people naturally understand. (Back to top)
Governor Philip Lowe of the Reserve Bank of Australia has ruled out NIRP for Australia. “I said previously that it was extraordinarily unlikely that we would have negative interest rates, and there's been no change to that thinking,” Lowe said. “The board is not contemplating having negative interest rates in Australia — I think the cost of that exceeds the benefits.”16 On 28 May, in speaking to a Senate Select Committee on COVID-19, he repeated that negative policy rate would be unlikely for Australia. The Reserve Bank of Australia has brought the cash rate to a historical low of 0.25%, set a target yield of 0.25% on 3-year Australian Government bonds, established a facility where banks can borrow for three years at 0.25% — they are focused on keeping funding costs low across the country and making credit available. Lowe provided forward guidance by sharing his expectation that the cash rate would likely stay low for a few years.17
In the 13 May 2020 press release about asset purchases, the Reserve Bank of New Zealand left open NIRP as a possibility: “The Committee noted that a negative Official Cash Rate (OCR) will become an option in future, although at present financial institutions are not yet operationally ready… Consequently, the Committee reaffirmed its forward guidance that the OCR will remain at 0.25 percent until early 2021. It was noted that discussions with financial institutions about preparing for a negative OCR are ongoing.”18
The Bank of Canada also does not rule out NIRP. According to in-coming Governor Tiff Macklem, “With respect to the effective lower bound at 0.25%, the Bank of Canada has elaborated a framework with unconventional monetary instruments, the possibility of using negative interest rates is included in that list. I think the reason it hasn’t been deployed is that… there are some disruptive effects of going negative. It’s hard to explain to depositors why their deposits are shrinking in their account when they’re not taking any money out. And when you’ve already got a disrupted financial system, you may want to be hesitant about introducing a new source of disruption. So, when you look at the current situation, yes, I’m quite comfortable with the effective lower bound where it is.”19 (Back to top)
According to the CME BoE Watch Tool, which uses MPC SONIA futures prices to gauge market expectations of the future course of Bank of England monetary policy, the probability is zero that the Bank of England would take their rate negative in a scheduled BoE meeting through 18 March 2021.
Chatham discussed the implications of negative rates for CRE borrowers previously on 4 May 2020. In thinking about potential implications, it’s important to keep in mind that, historically, base borrowing rates for floating-rate CRE loans (particularly LIBOR) have tended to follow the Fed Funds rate / Bank of England Rate; when the Federal Reserve / Bank of England cuts rates, LIBOR tends to fall and vice versa. With that in mind:
- As most CRE borrowers are now well aware, LIBOR-indexed loans typically have “floors” which preclude borrowers from benefitting from falling rates beyond a certain point. Most LIBOR loans, in our observation, have floors of at least 0% and many loans from non-bank lenders have floors that are even higher. The upshot is that CRE borrowers should not expect negative policy rates to translate into even lower financing costs for CRE investments.
- While loans typically have LIBOR floors, the interest rate swaps which many CRE borrowers use to fix the rate on floating-rate debt do not include a floor, by default. For loans with floors hedged with swaps without floors, negative LIBOR would create a mismatch between the economics of these two instruments — as LIBOR becomes negative, the borrower’s all-in loan coupon will increase. We are encouraging CRE borrowers to be more thoughtful about this mismatch and evaluate embedding floors in swaps (which increases the swap rate) or consider alternative hedging approaches that do not create this mismatch (like longer term, low strike caps).
- For hedge accounting-sensitive CRE borrowers (particularly publicly held REITs) this mismatch can create accounting, as well as economic, issues. For example, mismatches may disqualify the use of hedge accounting. If the Federal Reserve / Bank of England implements NIRP and LIBOR falls below zero, a mismatch between the floored loan and an unfloored swap which hedges that loan could result in a failure of hedge accounting, which would cause the changes in periodic swap valuations to flow through to the borrower’s income statement and introduce earnings volatility.
We’ll continue to provide updates in our resource center as market conditions evolve and implications for our CRE clients change. In the meantime, please feel free to reach out to your Chatham representative if we can support your LIBOR transition efforts.
4 https://www.project-syndicate.org/commentary/advanced-economies-need-deeply-negative-interest-rates-by-kenneth-rogoff-2020-05 , https://voxeu.org/article/negative-interest-rate-policy-post-covid-19-world
5 https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID3587349_code283885.pdf?abstractid=3460947&mirid=1 , https://www.imf.org/en/Publications/WP/Issues/2019/02/28/Negative-Monetary-Policy-Rates-and-Portfolio-Rebalancing-Evidence-from-Credit-Register-Data-46638
7 Interest on Excess Reserves, or IOER, is the interest that the Fed pays on balances that Depository Institutions hold in excess of required reserves
10 When the NAV of a MMF falls below $1 and MMF depositors recover less than their principal
11 “With a floating NAV, institutional prime money market funds (including institutional municipal money market funds) are required to value their portfolio securities using market-based factors and sell and redeem shares based on a floating NAV. These funds no longer will be allowed to use the special pricing and valuation conventions that currently permit them to maintain a constant share price of $1.00. With liquidity fees and redemption gates, money market fund boards have the ability to impose fees and gates during periods of stress. The final rules also include enhanced diversification, disclosure and stress testing requirements, as well as updated reporting by money market funds and private funds that operate like money market funds.” See https://www.sec.gov/news/press-release/2014-143
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