The Fed funds futures market, which trades bets on where the Federal Reserve’s benchmark interest rates are headed, has rallied this week to send prices for futures contracts in early 2021 above 100. Above 100 traders are pricing in negative interest rates from the Fed.
The Federal Reserve has currently set a benchmark rate between 0% and 0.25% and Federal Reserve Chair Jerome Powell has consistently said he’s opposed to negative interest rates. But traders increasingly don’t believe those protestations and see pressure from the coronavrisu recession and the threat of deflation pushing the Fed below 0%.
The trend in the Fed funds futures market is supported by trends in Eurodollar options, commonly used as a hedge against Fed moves, which is offering prices based on a Fed Funds rate as low as a negative 0.45 percentage points by the middle of 2021.
This is where Powell’s talk of the Fed using infinite resources to combat the coronavirus recession is turning back to bite the U.S. central bank. Powell’s aggressive stance reassured debt markets that were in danger of seizing up, but it has led to traders believing that Powell will do anything necessary–including going negative–to fight the recession and a crisis in the debt markets.
The more people who discuss the possibility that the Fed could go negative, the more the futures market will price in that possibility, and the greater the possibility that the Fed will go from considering the move to actually executing it. Yesterday DoubleLine Capital’s Jeffrey Gundlach warned that pressure will build for fed funds to go negative. Harvard University economist Kenneth Rogoff, co-author of This Time Is Different: Eight Centuries of Financial Folly, also said this week that the Fed should drop interest rates to less than zero.
Today the yield on the benchmark two-year Treasury fell to just 13 basis points, 0.13 percentage points, above 0%. The previous record low for the two-year yield, 0.1431%, dated from September 2011 amid concern over Europe’s sovereign-debt turmoil and as the U.S. economy struggled to recover from recession. It was above 1% as recently as February 28.