However, the US Federal Reserve Chairman Jerome Powell came out in an interview to say that the Fed will not implement a negative interest rate monetary policy to fight the fallout from the COVID-19 pandemic.
There’s no telling what might happen, but according to Reuters, the Fed-funds futures market has already started pricing in negative interest rates.
In fact, this monetary policy has been implemented in Europe by the European Central Bank (ECB) in 2014 and Japan by the Bank of Japan (BoJ) in 2016 in a desperate effort to stimulate its economy and fight the effect of deflation.
How Will Negative Interest Rates Affect The US Stock Market?
Undeniably, interest rates have a big impact on the U.S. economy.
More specifically the federal funds rate set by the Federal Open Market Committee (FOMC).
It is the rate at which banks pay to borrow from the Fed.
When the Fed makes changes to the federal funds rate, it has an impact on markets as the cost of borrowing will go up or down for businesses and individuals.
The impact of this is almost immediately on the stock market, however, it will take about 12 months or so before you can see any real effects on the broader economy.
In theory, lower or negative interest rates will positively affect earnings and share prices.
This is so as negative interest rates will spark growth because it encourages borrowing and spending, which in turn stimulates the economy.
But how will this actually impact the U.S. stock market? Let’s find out!
What Are Negative Interest Rates?
Well, I’m glad you asked.
Adjusting the interest rate is a traditional monetary policy utilised by central banks to control inflation in a country’s economy.
In an effort to fight deflation (reduction of the general level of prices in an economy), the central bank reduces interest rates and the cost of borrowing to spur individuals and businesses to take more loans and increase consumption. This will in theory increase demand, and see prices rising.
Source: Giphy
Negative interest rates are a more extreme version of this interest rate monetary policy.
Firstly, negative interest rates incentivise commercial banks to lend out the money, as they will need to pay the central banks to store the money there instead of collecting interest on it.
They will be encouraged to lend the money out at low-interest rates to other banks, businesses and consumers.
With negative interest rates, it will become costly for individuals and businesses to hold on to money.
Instead of their savings earning interest; they might get charged a fee by the bank for depositing their money.
Theoretically, this will incentivise people to borrow more, save less and spend more which will stimulate the economy.
Negative Interest Rates in Europe and Japan
Negative interest rates have already been implemented in Europe and Japan.
Back in 2014, when Europe was facing the Eurozone crisis, the European Central Bank (ECB) cut its deposit rate to -0.1% in an effort to fight off deflation and take the European Union out of a prolonged crisis.
As of April 2020, the ECB’s deposit rate stands at -0.5%, the lowest in its history.
Similarly, the Bank of Japan (BoJ) implemented negative interest rates in 2016 and as of April 2020, the interest rates remain negative at -0.1%.
Although it was able to provide a short term jolt to the economy, the jury remains out on the consistent long term impact of negative long term interest rates.
What Happens When Interest Rates Go Negative?
Normally, when the Fed cuts interest rates, it is done in an effort to stimulate economic activity when the country’s economy is slowing down.
Economists and investors view the cutting of interest rates as a spark to ignite growth because it encourages individual and corporate borrowing and spending.
This, in turn, will stimulate the economy.
Consumers will be incentivised to spend more as the negative interest rates will make them feel that they can finally afford to buy that new car or new house.
Companies will also be able to acquire capital at a lower rate and invest in growing their business.
This cheap debt will allow companies to invest in acquisitions and expansions, improve their operations which will improve their future earnings potential which will more than likely result in higher stock prices.
The companies that tend to benefit from this are the industries that pay dividends like utilities and real estate investment trusts (REITs) as the negative interestrate will help to reduce financing costs for any asset acquisitions.
In addition, larger companies that have strong balance sheets and steady cash flows will be able to profit from more affordable debt financing.
Negative Interest Rate’s Potential Impact on Expectations of Future Growth
In reality, even if nothing happens to consumers or companies, the stock market will still react to interest rate changes.
The Fed announcing negative interest rates will undoubtedly have a psychological impact on investors.
Source: Giphy
Typically, when the Fed implements a cut in interest rates, investors would assume that individuals and companies will spend and invest more causing stock prices to go up.
However, there are instances where these generalised reactions will not occur when the expectations do not match the reality of the Fed’s actions.
For example, if there is widely spread rumour going around that the Fed will announce negative interest rates. However, the Fed only announces a cut in interest rates to zero instead.
This news might potentially cause stock prices to drop because the market is assuming that the negative interest rates have already been priced into the market.
15 Mar Fed Interest Rates Cut
A good example of this would be when the Fed cut interest rates to almost zero to fight the fallout from the COVID-19 pandemic on 15 Mar.
The S&P 500 dropped 12% to 2,386.13 — hitting its lowest level since Dec 2018.
As the economy was weakened by the COVID-19 pandemic, the jolt provided by the announcement of lower interest rates was not enough to stop stock prices from dropping.
If you would like to have a better idea of what on with the S&P 500, do read this piece about why the S&P 500 is recovering now.
Negative Interest Rate’s Potential Impact on Money Market Funds
The Fed has been very strong in its opposition of negative interest rates, as it is afraid this monetary policy will overturn parts of the U.S. financial system.
More specifically, money-market funds which are particularly sensitive to negative interest rates and bond yields.
By definition, money market funds are mutual funds that purchase short-term debt from quality companies, banks, governments and municipalities and provide them with an important source of capital.
Investors who buy money-market funds get a highly liquid and safe asset that will retain its value amidst the volatility of financial markets. They will also receive investment returns from the fund.
However, the returns from these instruments are reliant on the applicable market interest rates.
Negative interest rates can potentially wipe out the returns from such funds. Theoretically, investors could also lose a small portion of the principal amount they invested.
Negative Interest Rate’s Potential Impact on Bonds
I’ve included bonds in this discussion as it will have an indirect impact on the U.S. stock market.
Source: Giphy | Not not that bond…
For investors who are more focused on investment income, a low or negative federal funds rate will mean a lower yield for more than bonds.
Interest on new U.S. government bonds, which paid more than 6% 20 years ago, has dropped to pathetically low levels recently.
Last Thursday (14 May 2020), the yield for 10-year notes was less than 0.7% annually, and for 30-year bonds, less than 1.3%.
If the negative interest rate is implemented, this yield would drop further.
This will likely prompt bond investors to take their money out of the bond market into the stock market.
The increased demand and influx of new capital will then cause the U.S. stock market to rise.
Negative Interest Rates and the Stock Market
When it comes down to it, there is generally an inverse relationship between interest rates and the stock market.
Typically, when the Fed cuts interest rates, it will cause the stock market to go up as it will stimulate the economy, and psychologically affect investors expectations of the stock market.
Not to mention the people taking money out of the bond market and putting it into the stock market due to low-interest rates.
However, there is no guarantee of how the market will react to negative interest rates given how volatile the markets have been since the outbreak of the COVID-19 pandemic.
Also, negative interest rates will push down the entire yield curve and cut the margins financial institutions earn from lending.
Although it can give the stock market a short jolt, prolonged negative interest rates might hurt the health of financial institutions and they could hold off on lending and damage the economy.
Disclaimer: The information provided by Seedly serves as an educational piece and is not intended to be personalised investment advice. Readers should always do their own due diligence and consider their financial goals before investing in any stock.
History student turned writer at Seedly. Before you ask, not a teacher.
I hope to help people make better financial decisions and not let money control them.
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