The Fed’s Final Frontier—Negative Rates or Yield Curve Control?

Given fears of a COVID-19 resurgence and US election uncertainties looming, many investors are wondering what comes next for policymakers in terms of supporting the economy. Our Fixed Income CIO Sonal Desai weighs in on the possibility of negative US interest rates or other measures.

As policymakers venture further and further into uncharted territory, markets have to ponder what the US Federal Reserve’s (Fed’s) next frontier will be. Investors first focused on the possibility of negative interest rates, then they realized that yield curve control (YCC) was a more likely alternative—and indeed at the press conference following the Federal Reserve’s June policy meeting, Chairman Jerome Powell confirmed they had discussed the option.

Do We Actually Need More Easing?

After this week’s strong rebound in May US retail sales—and the surprise 2.5 million recovery in May non-farm payrolls—the Fed may want to take more time to monitor the situation. Some real-time indicators suggest a healthy rebound might already be underway (as I discussed in my previous On My Mind). But the outlook remains highly uncertain, given fears of a second wave of COVID-19 contagion and the November elections.

The Fed also needs to assess the impact of the policy stimulus already underway: The Fed’s own actions so far appear to have been effective in boosting credit and stabilizing financial markets—and the Fed has so far deployed only a fraction of its committed asset-purchasing firepower. Moreover, an additional round of fiscal stimulus is under discussion.

I think the Fed will wait till after the summer and will lean towards YCC if more stimulus seems warranted—I see negative rates as very unlikely. Will the Fed have to step in again? In my view, probably yes. Even if we do continue to experience a V-shaped rebound in the next couple of months, the recovery will then likely slow and it will take a while for the US economy to get back onto the pre-COVID-19 path (see our recent white paper, “US Macro Outlook: Let’s Bend the Economic Growth Curve.”) Moreover, equity markets appear to be already priced for perfection, which means that pre-election volatility could set the stage for an adjustment in stock prices, bringing the usual market pressure to bear on the Fed to step in.