Concerns rise about negative bond yields reaching U.S.

As the longest economic expansion in U.S. history continues to get older, it ’s only natural that speculation is building over when the next recession will hit.

But this economic cycle carries with it the unprecedented potential for something known as a negative-interest-rate policy, and some now see that as inevitable.

“If the next recession is anything but mild, the Fed will go to negative rates, which will be a complete and utter disaster,” said Paul Schatz, president of Heritage Capital.

Citing as a reference point the Federal Reserve’s response to the 2008 financial crisis — driving interest rates down from 5.5% to zero and then layering on $4 trillion worth of quantitative easing — Mr. Schatz expects the Fed to embrace the kind of negative-rate policy that has become common in many parts of Asia and Europe.

“They’re already floating the trial balloon of negative rates,” he said. “It’s not going to work because it’s a vortex that destroys your bond market.”

As global central bankers have cut rates in a desperate attempt to stimulate economic growth, the result has been approximately $13 trillion worth of negative-yielding sovereign debt outside the United States.

Last month, in an interview with InvestmentNews, Allianz chief economic adviser Mohamed El-Erian said it is “very unlikely” the U.S. will employ negative rates because “the Fed fully understands the risks and costs. And secondly, it’s very unlikely because I do not believe we’re going into a recession.”

In an interview for this story, Mr. El-Erian said the chance that negative rates will spread to the U.S. is limited by the effects the policies are having in Europe.

“It’s highly unlikely because of increasing evidence that the experiment of negative rates in Europe is failing,” he said. “The right option is to employ a comprehensive policy approach that doesn’t rely on central banks. If that’s not possible, there is a scope for the Fed for a lot of quantitative easing.”

Mr. El-Erian added that the European central bankers who initially embraced negative rates are now divided over the policy’s effectiveness.

“Going negative has been shown to encourage savings, it encourages excessive risk-taking, it allows zombie companies to stay alive and it increases the misallocation of resources across the country,” he said.

Negative yields could mean investors would have to pay for the privilege of owning a bond or storing money in a savings account. While that possibility has been kicking around as a potential threat to the U.S. for a half-dozen years, the voices citing the threat are getting louder.

Michael Bazdarich, an economist at Western Asset Management Co., published a report Feb. 6 arguing that negative rates are both inevitable and technically manageable from a financial market perspective.

Like Mr. Schatz, Mr. Bazdarich doesn’t believe the Fed has enough cushion, with rates currently below 2%, to avoid negative rates as a tool for fighting a recession.

Mr. Bazdarich was not available for an interview for this story, but in his paper he explained that in each recession since the 1970s, the Fed has responded by cutting short-term rates by more than five percentage points.

In the wake of the financial crisis, the Fed funds rate peaked at 2.4% in late 2018 and is currently hovering around 1.5%.

“Short-term rates are likely to stand below 2% when the next recession emerges,” Mr. Bazdarich wrote. “If the Fed is to pursue rate cuts on anything approaching the scale seen in previous recessions, a move to the negative is inevitable.”

The report says the Fed can either respond to slower growth by “doing nothing to help the economy weather the next recession or embark on a negative-rate policy.” Mr. Bazdarich cites Asia and Europe as proof that “there is nothing in bond math requiring positive yields.”

As illogical as it might seem, a negative Fed funds rate would mean commercial banks would pay other banks to borrow cash reserves from them. Mr. Bazdarich said banks will do it because it will cost them even more to hold the reserves.

The ripple effect could be punishing to anyone relying on fixed-income investments.

“Negative rates become a black hole that sucks you in and you can’t get out,” Mr. Schatz said. “Many bond mutual funds and pension funds have strict rules on what they must invest in. Why on Earth would anyone buy a $100 CD only to get $99 back a year later? But that’s what happens when funds have to own Treasuries and those Treasuries pay negative rates.”

Michael Hennessy, founder and chief executive of Harbor Crest Wealth Advisors, agreed that turning to negative rates to battle a recession could be crushing to anyone in or near retirement.

“The issuance of negative-yielding debt would hit the baby boomers the hardest, just as that cohort moves out of the workforce and into retirement,” he said. “Additionally, banks would need to find creative ways to replace the income they need to generate from their deposits at the Fed. This would likely mean increased fees to consumers, and potentially even negative deposit rates to the average saver.”

But, worst-case scenarios aside, Mr. Hennessy believes a recession that would lead to negative rates is not yet a real threat.

“There is increased talk, but right now I don’t see a likelihood of a recession,” he said. “The unemployment rate is 3.5%, the stock market is at all-time highs. There’s no reason at all to go to negative rates right now.”

Mr. Bazdarich writes that Fed officials are also “confident they will not need to resort to negative interest rates. However, as Mike Tyson once said, everyone has a plan until they get punched in the face. It is hard to imagine that Fed officials will not resort to any tactic available or conceivable when the economy appears to be in need of it, and it’s hard to see Congress standing in the way.”