But forget QE-4.
The Germans, with Teutonic precision, call them “Punishment Interest.” Negative interest rates are spreading from the ECB’s negative deposit rate across the bond market and to some savings accounts in the Eurozone. The idea is to enrich existing bond holders and flog savers until their mood improves. Stock prices are allowed to get crushed by reality.
Negative interest rates destroy one of the most essential mechanisms in an economy: the pricing of risk. Investors end up taking huge risks with no reward. Many of them will get cleaned out down the road.
In Switzerland, punishment interest already causes “perverse unpredictable effects,” as mortgage rates have started to soar. It’s wreaking havoc in Denmark and Sweden. Bank of Canada Governor Stephen Poloz let the idea float that he’d unleash punishment interest to destroy the Canadian dollar. The Bank of Japan announced Friday morning – timed for maximum market effect – that it too would inflict negative interest rates on its subjects.
In the US, Ben Bernanke has been out there preaching to the choir about them. Over-indebted corporate America, except for the banks, would love this absurdity; it would allow them to actually make money off their mountain of debt.
“Potentially anything – including negative interest rates – would be on the table,” Fed Chair Janet Yellen told a House of Representatives committee in early November.
Fed Vice Chair Stanley Fischer has been publicly obsessing about them for a while. Monday, during the Q&A after his speech at the Council on Foreign Relations, he said that negative interest rates are “working more than I can say I expected in 2012.”
It seems to be just talk. But negative interest rates are already baked into the official scenario for 2016. It’s in the Board of Governors’ new report on the three scenarios to be used in 2016 for the annual stress test that large banks are required to undergo under the Dodd-Frank Act and the Capital Plan Rule.
The scenarios – baseline, adverse, and severely adverse – start in the first quarter 2016 and also include economic factors in the Eurozone, the UK, Japan, and the weighted aggregate of China, India, South Korea, Hong Kong, and Taiwan.
In the “severely adverse scenario,” things get interesting.
But don’t worry, the Fed emphasizes that “this is a hypothetical scenario” for the purpose of a bank stress test and “does not represent a forecast of the Federal Reserve”:
The severely adverse scenario is characterized by a severe global recession, accompanied by a period of heightened corporate financial stress and negative yields for short-term U.S. Treasury securities.
GDP begins to tank in Q1 2016 and by Q1 2017 is 6.25% below pre-recession peak. The unemployment rate hits 10% by mid-2017. Headline CPI rises from an annual rate of 0.25% in Q1 2016 to 1.25% by the end of the recession. Asset prices “drop sharply,” with stocks down “approximately 50%” through the end of this year, accompanied by a surge in volatility, “which approaches the levels attained in 2008.” Through Q2 2018, home prices plunge 25%, commercial real estate prices 30%.
“Corporate financial conditions are stressed severely, reflecting mounting credit losses, heightened investor risk aversion, and strained market liquidity conditions.” Bond spreads blow out, with the yield spread between investment-grade corporates and Treasuries jumping to 5.75% by the end of 2016.
So things are going to get ugly. And here is what the Fed is going to do next:
As a result of the severe decline in real activity and subdued inflation, short-term Treasury rates fall to negative ½ percent by mid-2016 and remain at that level through the end of the scenario.
Short-term Treasury rates can only fall to a negative 0.5% if the fed funds rate is at that level.
And the whole yield curve comes down, with the 10-year Treasury yield collapsing to 0.25% by the end of this quarter, but then “rising gradually” all the way to a whopping 0.75% by the end of the recession and to 1.75% by Q1 2019 (it’s 1.93% now).
The international component “features severe recessions” in the Eurozone, the UK, and Japan, and a mild recession in developing Asia, along with a “pronounced decline in consumer prices.”
Due to “flight-to-safety capital flows,” the dollar appreciates against the euro, the pound, and the currencies of developing Asia, but will “depreciate modestly” against the yen, “also in line with flight-to-safety capital flows.”
One of the differences between the severely adverse scenarios for 2015 and 2016? The scenario this year “features a path of negative short-term U.S. Treasury rates.”
Who are the winners? Existing holders of long-term Treasuries who will benefit from “larger gains on the existing portfolio of these securities.”
However, the Fed makes no promises about stocks, having seen the debacle playing out in Europe where stocks have plunged despite negative interest rates. And banks will get hit as “negative short-term rates may be expected to reduce banks’ net interest margins and ultimately, to lower PPNR [pre-provision net revenue].
And there you have it. The Fed already has a “path” to negative interest rates.
But note: not a single word about QE.
If the stock market crashes 50% this year, as the “severely adverse” scenario spells out, all the Fed will do is slash the fed funds rate to a negative 0.5%. And if stocks crash only 25% this year, instead of 50%?
That’s the case in the Fed’s middle scenario, the merely “adverse” scenario. Short-term rates will “remain near zero” it says – maybe slightly below where they’re right now. So no negative interest rates. And no QE either. Stocks can go to heck, the Fed is saying. It’s worried about credits, particularly high-grade credits. Junk bonds and stocks are on their own.
And this concept of switching to negative interest rates and away from QE is even in line with the Bank of Japan’s desperate head fake. Read… QE in Japan Nears End: Daiwa Capital Markets