Market Overview

14 May 2020

The Hen and the Egg Quiz of the Negative Rates in the US

The fundamental background outside the markets has changed little ideologically over the past 24 hours. The same three top discussions are in focus: how realistic is the chance for a truly strong second wave of infections as the economy reopens, how safe is the temporary break in American-Sino relations, and whether the possibility of switching to negative interest rates in the US still exists or not in connection with the first two sources of worries?

All three questions have no clear answer yet. So, the markets are at a certain crossroads. Nevertheless, what has emerged - at least relatively new - from the category of positive and negative arguments?

The Federal Reserve (Fed) Bank of New York has started purchases of exchange-traded funds (ETFs) in frame of the Secondary Market Corporate Credit Facility (SMCCF) program. Its official website says that the SMCCF "may purchase U.S.-listed ETFs whose investment objective is to provide broad exposure to the market for U.S. corporate bonds", and they will consider several additional factors in determining which ETFs will be eligible for purchase. The New York Fed provides the following details for now: "those considerations include: the composition of investment-grade and non-investment-grade rated debt, the management style, the amount of debt held in depository institutions, the average tenor of underlying debt, the total assets under management, the average daily trading volume, and leverage, if any".

Asset management giant BlackRock is the operator under the supervision of the Fed, CNBC reports. BlackRock will buy ETFs that hold bonds of the so-called "fallen angels" companies. These securities were previously classified as investment securities, but were reduced to speculative or junk ratings. According to Bloomberg, a "fallen angel" is a bond that is downgraded to BB+ or below (categories considered junk, or, more politely, high yield) by at least the two of the three major rating firms - Moody's Investors Services, S&P Global Ratings and Fitch Ratings - after being formerly rated BBB- or higher (categories that are investment grade). Downgrades can happen when a company isn't creating enough revenue or generating enough cash to service its debt, or when it takes on so much debt that its financial leverage - usually calculated by debt as a measure of earnings - becomes disproportionate.

Of course, such purchases are an encouraging preventive measure for the markets, which may prevent a possible collapse of bad corporate debts in the future. However, few financiers are happy with the fact that the Fed is forced to take so many different classes of securities on its bloated balance sheet. These measures reduce the likelihood of grim consequences for the economy from the second wave of infections, if it comes before September. And the following warnings from the White House's main medical advisor Dr. Fauci on Wednesday came the words of the World Health Organisation's (WHO) emergencies expert Mike Ryan. "It is important to put this on the table: this virus may become just another endemic virus in our communities, and this virus may never go away," he said in course of online briefing. "I think it is important we are realistic and I don't think anyone can predict when this disease will disappear," he added. "I think there are no promises in this and there are no dates. This disease may settle into a long problem, or it may not be," he resumed. Ryan even noted that vaccines exist for other illnesses, such as measles that have not been eliminated. That somewhat lowered hopes for the appearance of a miracle vaccine that will finally finish off the coronavirus.

The Fed's Chairman Jerome Powell warned on Wednesday of extended economic weakness due to the coronavirus pandemic but did not mention new central bank support measures for the banks or economy. The US economy will take some time to get back to where it was, Mr Powell said in a webcast. "The market seems to be looking to the Fed for support and the Fed said look somewhere else," said Jeff Kleintop, chief global investment strategist at Charles Schwab. "The market took away that maybe there's more bad news out there than they'd been pricing in," he added.

It is difficult to say what additional measures the market could expect from Mr Powell after the already unprecedented aid packages worth trillions of US Dollars, but the fact is that the S&P500 and Nasdaq stock indexes actually fell yesterday for the second day in a row. That happened just after Mr Powell's speech but maybe the reason was also that investors got scared by the WHO's representative. Many market participants were relieved by Mr Powell's continued indication that the Fed would not push interest rates below zero. But the issue is extremely complex and delicate. Fed members continue to reject negative rates for now, but they do not take an oath on the Bible, so that even some big market players doubt.

"While there are certain circumstances in which negative rates become a viable option for the Fed, for the time being they look unlikely - at least not before other policy options are exhausted," said Bill Diviney, a Senior Economist at ABN Amro. In his interview for CNBC, Zach Pandl, co-head of the global foreign exchange, rates and emerging markets strategy at Goldman Sachs remarked that there is a possibility of a second wave of coronavirus cases that could derail the upcoming economic recovery, so that could change the Fed's mind on negative rates. "If the economy has another big setback ... where you have a second wave of infections and it would really take the recovery off course, then I do think that that opens up a possibility of a range of additional actions... Even in that scenario, I think fiscal policy would be the first step. I don't think that cutting rates to negative territory would potentially be very helpful even in that environment. But who knows, policymakers are going to want to try new things if the economy is really struggling for a period of time," he said.

The most interesting thing in this regard is that not only a second wave of coronavirus could make the Fed rethink negative interest rates, but also vice versa, if the Fed may set out to dress up the negative rates in the garb of some economical excuse but for the sake of extremely cheap refinancing of US public debt and reducing the cost of the US Dollar. The authorities may whip up tension intentionally inventing drawing the devil in much more black colours than he actually is seen. Should we consider a possible second wave of infections as a hen, and negative interest rates followed by the market's drop as a potential egg, or should we consider that the desire for negative rates may become the egg from which an imaginary hen of a second infection wave could be born although that does not yet exist in reality. This does not change much if both the hen and the egg still appears in one or another sequence.

What comes first, the hen or the egg? This age-old question that worried the sages, as always, will not be important in the end. So, even if the information hysteria is excessive in comparison with reality, it is unlikely that this fact may save the markets from another wave of decline. Of course, if a wave of this hysteria and/or a wave of this infection does occur. There are a lot of positive scenarios, in which the markets may continue to believe in good things and just continue to grow. But theoretical issues that cause the markets' worries. are just being discussed.

So, another theoretical version of the hen that could deliver an egg of negative rates could be the trade tension between China and the US. This front is relatively quiet for now. There are no more open accusations from the White House against the Chinese authorities about "concealing" the virus. Republican Senator Lindsey Graham proposed to the US Senate a bill on "Chinese responsibility" for COVID-19, suggesting that the country's President Donald Trump should impose sanctions if China does not publish a full report on the outbreak. But the document was supported by only eight more Republican senators. So far the Chinese side allows retaliatory sanctions only against individuals and organisations, as shown by an article in the Chinese Global Times, referring to its high-ranking sources. Reuters sources reported that a temporary decision was made by an independent board overseeing billions in federal retirement Dollars that it would indefinitely delay plans to invest in some Chinese companies. The markets are also waiting for an announcement from Mr Trump on the fulfilment of Phase One of the trade deal. However, no one knows whether to consider the lack of news on this issue as good or bad news.


Analysis and opinions provided herein are intended solely for informational and educational purposes and don't represent a recommendation or investment advice by TeleTrade.

Lysakov Sergey
Market Focus
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