Fed Funds Futures are beginning to have second (or is it third?) thoughts about the likelihood of negative interest rates, so let’s talk about it in 6 easy steps:
#1: Today’s Fed Funds rate is 0.05%, right where it has been since May 1st. Fed Funds Futures price in rates between 0.01% and 0.05% from now through April 2021. So far, so good.
#2: But the May 2021 contracts priced today at 100.005; take 100 and subtract that number and you get a projected Fed Funds rate of -0.005. The peak pricing in this market is currently August 2021, with a price of 100.025. That implies negative 0.025% Fed Funds.
#3: We are not back to where we were on May 8th, when the August 2021 contract expected -0.05% (the mirror image of today’s +0.05%), but it’s still troubling we’re here at all. There’s mention of a Fed piece on negative rates in the links below, but we doubt this is what’s driving market action just now.
#4: One reason for Fed Funds Futures not dismissing negative rates: 2- and 5-year Treasury yields are not rising even as equity markets push their way higher. Two years went out at 0.17% today, and five years at 0.32%. Here is the 1-year yield chart for these securities:
#5: TIPS Spreads, one measure of what markets expect for future CPI inflation, point to very low inflation and the volatility here says deflation is not off the table. Here is a chart of 5- and 10-year TIPS break evens, which sit at 0.84% and 1.18% forecast future inflation respectively. The 10-year timespan for this chart shows they remain near decade lows.
#6: Finally, consider a very long run view of US CPI inflation in the form of annual percentage changes in the headline number. The thing to focus on here is how inflation drops during or after a recession (the grey bars). It always does, but the amount varies between 2 and 7 points. This is perhaps the simplest explanation for why Fed Funds Futures discount negative rates. If the US sees -2% inflation in 2021 (4 points lower than the pre-COVID economy), then negative interest rates could still be positive real rates.
Summing up: in the end we don’t think negative Fed Funds rates are likely but in reviewing these charts we’re once again reminded of why they are possible, and the market is not “wrong” in pricing this possible outcome. The clearest equity investment implication is determining how this overhang might affect bank stocks specifically and Financials generally. We are mindful of how poorly European banks have performed in a negative rate regime and worry that sort of valuation compression could occur in US equity markets. For those clients interested in a cyclical recovery trade, we continue to favor Energy. If nothing else, we don’t think negative oil prices will happen again. We can’t give the same assurance on interest rates.