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Negative Interest Rates: Who Will Blink First – The Fed or The Market?

Written by: Gary Ashton

Other central banks, such as those in Europe and Japan, are doing it. President Trump tweets about it. The market is already pricing it in Fed Fund Futures. So why is the US Federal Reserve Chairman Powell against the idea of using negative interest rates as a policy tool? The negative interest rate question is one the market has been asking for some time. There is not a lot of explanation from the Fed beyond “it is not being looked at right now,” and “it is not currently an attractive monetary policy.”

Supporters of negative rates argue negative rates could boost demand, raise employment, and save firms from default. In contrast, those against negative rates say they destroy banks’ balance sheets, distort age-old lending and borrowing concepts, and could be hard to reverse once implemented. Only time will show who is right. For now, anyway, it is a staring contest between the market and the Fed on who will blink first on negative rates.

Markets are currently pricing in a drop below zero sometime between now and the end of 2021. The Effective Federal Funds Rate sits at 0.05%, down from 2.4% one year ago. As a reminder, the federal funds rate is the interest rate at which depository institutions such as banks trade federal funds (balances held at Federal Reserve Banks) with each other overnight. It is also a benchmark for the realization of policy rates set by the Fed at its monthly meetings.

Negative Rates Benefit Gold and Bond ETFs

The issue of negative rates is essential for every asset class (equity, bonds, commodities) because these rates directly affect the price of these instruments. One big winner from negative rates could be gold because although gold does not pay any interest or coupons, it also does not take investors’ cash away in a negative rate environment. As the idea of negative rates gets priced into markets, gold is rallying. Gold Futures (CME: GC) closed last week at $1765.30 per ounce and is up nearly 15% in 2020. Gold-based ETFs are also performing well. The SPDR Gold Trust ETF (AMEX: GLD) is up 13.88% this year.

Another asset class that could benefit from negative rates is bonds because the price of a bond and its yield are inversely related. So as rates go down, bond prices go up. If the Fed pushes rates down into negative territory, bond prices should rally. Some bond ETFs are already benefiting from the prospect of negative rates. For example, the iShares 7-10 Year Treasury Bond ETF (NASDAQ: IEF) is up 10.31% in 2020. Longer-dated bonds, like those in the iShares 20+ Year Treasury Bond ETF (NASDAQ: TLT), are up even more this year, returning 21.67% as of last week’s close.

Related: How to Correctly Invest in a Downturn

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