Investors betting on interest rates have signaled that the U.S. Federal Reserve could push its benchmark rate below zero for the first time ever within the next year. While policy makers have tried to rein in such speculation, there’s an undercurrent of worry among investors that they should protect against this scenario as the global economy reels from the pandemic. Sub-zero central-bank rates have been a reality for years in Europe and Japan, and the Bank of England isn’t ruling them out. Fed officials have consistently opposed going negative. But that hasn’t stopped the gyrations in derivatives markets from driving the debate.

1. What do negative rates mean?

The idea is to provide another spur to the economy by stimulating more lending. The theory goes that by introducing sub-zero benchmark rates, households and consumers will be incentivized to borrow and spend. Investors would shift purchasing to other short-term or riskier assets and the rates on those assets would fall, making borrowing cheaper. Whether that’s worked in the regions that have tried it, or whether the disruption of negative rates outweigh their benefits, is a matter of hot debate. President Donald Trump has regularly heckled the Fed to venture below zero -- saying doing so would be a “gift” to the U.S. economy.

2. What are U.S. markets saying?

Traders forged ahead with negative-rate bets during May, with implied yields on futures contracts linked to the federal funds rate going below zero. That’s a signal that the Fed could, by mid-2021, cut its key rate below the current range of zero to 0.25%, something it’s never done before. Analysts say the positions were influenced by a confluence of reasons, including technical factors. Still, the speculation is happening against a backdrop of unprecedented risks. One fear is that the economic meltdown might trigger deflation, or a downward spiral of falling consumer prices that’s a worry for central banks.

3. What were some of the technical factors?

In accounting-driven moves, banks bought options on instruments such as fed funds futures as a way to protect themselves from the risk that assets based on other rates, like Libor, would go negative. Moreover, dealers left short on the other side of those options may have been forced into stop-outs that limited the losses. The Fed managed to quash some negative expectations for the fed funds rate, only to see something else -- the rate on overnight repurchase agreements -- dip below zero. At the same time, bets on negative rates spread to the U.K. Questions about whether there’s a risk of rates going negative somewhere are bound to come up again.

4. What do Fed officials say?

Fed Chairman Jerome Powell has repeatedly pushed back against the idea of negative benchmark rates, without completely ruling it out. During the last recession, which ended in 2009, Fed officials considered a variety of tools and chose not to deploy them, the chairman points out. “Negative interest rates is probably not an appropriate or useful policy for us here in the United States,” Powell said in an interview with “60 Minutes” that aired May 17, adding that the evidence on whether it works is “quite mixed”. His Fed colleagues tend to agree. Dallas Fed President Robert Kaplan said on May 14 that below-zero rates would do “great damage” to money markets and financial intermediaries. A week later, San Francisco Fed President John Williams said policy makers have the tools they need, without having to go below zero.

5. Why the objections?

For the most part, it’s unclear how much of an economic gain negative rates would deliver, and there are worries they could roil financial markets. In a 2010 memo, Fed staffers raised concerns about the impact on banks and money market funds. Some economists argue that there’s a limit on how far rates can be pushed down before they perversely start to hurt banks, and through them, the economy.

6. What are the worries?

Already facing a likely surge in pandemic-based defaults, U.S. banks fear pinched profits: They’d have to pay to hold deposits at the Fed, rather than collect interest, making them perhaps even less likely to extend credit. The experience in Europe -- where bank profits were sapped by negative rates, contributing to tepid economic growth -- is not one U.S. banks are eager to repeat.

7. Why are money-market funds a consideration?

The risk in money markets relates to concerns that if the interest income they produce for investors disappears as rates go below zero, their customers could start boycotting them and seek yield elsewhere. The U.S. relies on these markets -- at a size of roughly $4.8 trillion -- more than economies elsewhere. In minutes of an October Fed meeting, officials saw the risk of “significant complexity or distortions to the financial system.” Furthermore, it’s a policy that would arguably target the wrong end of the yield curve: negative rates have the biggest immediate impact on short-term rates, while longer-term rates serve as benchmarks for mortgage borrowing and corporate credit.

8. What do U.S. lawmakers say?

While Trump has repeatedly called on the Fed to consider negative rates, other lawmakers may think otherwise. There are even suggestions it could be illegal. In 2008, the Fed gained explicit authority from Congress to pay commercial banks interest on reserve balances deposited at the central bank. It’s not clear whether that authority extends to establishing negative rates on those reserves. When the Fed first reduced rates to a range of zero to 0.25% in 2008 and kept them there for seven years, it was frequently criticized by lawmakers for short-changing savers.

9. What’s happened in countries that used negative rates?

The European Central Bank became the first major institution to push short-term interest rates below zero in 2014, as it tried to combat a lingering economic slump. The Bank of Japan followed at the start of 2016, and by the middle of that year some 500 million people in a quarter of the world’s economies ended up living with rates in the red. Since central banks provide a benchmark for all borrowing costs, negative rates spread to a range of fixed-income securities. Central bankers have recently shown a reluctance to push benchmark rates deeper into negative territory and banks have criticized the policy. Sweden’s Riksbank became the first major central bank to end its policy of zero rates in December.

10. What else can the Fed do to spark demand?

Fed officials have already slashed rates and pledged to buy a sweeping amount of assets. But they have other tools -- such as larger-scale bond purchases and committing to stronger interest-rate guidance to try to combat the recession. Yield-curve control -- whereby the Fed targets a specific level of yield on government bonds at one or more maturities -- may be another efficient way to tether borrowing costs that are most relevant to growth. The Fed studied the possibility of lowering rates below zero in the 2008-2009 financial crisis and its aftermath and found it “wanting,” Vice Chairman Richard Clarida said in March 2019.

For more articles like this, please visit us at bloomberg.com

©2020 Bloomberg L.P.