Why negative Fed rates have everyone worried

Talk of the Federal Reserve introducing negative interest rates has left many investors concerned as they contemplate risks to the current credit cycle and the wider global economy.

A negative interest rate policy, or NIRP, essentially charges banks to hold cash at a central bank in the hope that they will instead lend to the real economy. Many expect banks to pass on this disincentive to save to its customers by trimming rates or by ramping up borrowing costs.

The policy is increasingly being seen as a viable option for central bankers after Japan's move below zero last week, which also sent the country's 10-year Treasury in negative territory for the first time ever.

But global stocks are seemingly depressed on anticipation of such a policy move by other developed nations. This came to a head this week with the Federal Reserve telling banks to prepare for such a scenario in a round of stress tests coming up this year.

"Negative rates are a de facto tax on the banking system," Paul Donovan, global economist at UBS, said in a note on Tuesday. This sort of thinking - along with balance sheet and capital concerns - is just one of the reasons why banking stocks in Europe have tanked this week.

"If banks find themselves targeted then there is a risk that the credit cycle may be impacted," Donovan added in the note, underlining that even deeper negative rates in Europe could stifle lending and ruin a very fragile recovery in the region.

Jim Reid at Deutsche Bank said in a note Wednesday that further market stress could lead to a "self-fulfilling problem." As a minimum, he said it could hit bank lending that had recently helped European growth, in turn weakening the operating environment for banks further.

The Federal Reserve may only be hinting at the prospect of negative rates but it has already become a reality in Europe. The European Central Bank (ECB) , the Danish National Bank (DNB), the Swedish Riksbank, and the Swiss National Bank (SNB) have all pushed key short-term policy rates into negative territory.

Analysts say the real focus lies with how money markets and money market mutual funds deal with the problem of diminished returns due to NIRP. This sector trades highly liquid securities with very short maturities and sees large flows of retail investor cash as they provide investors liquidity and capital preservation.

"(U.S.) money funds could consider charging customers, reducing management fees, seeking subsidies from fund sponsors, or closing their doors," Mark Cabana, a rates strategist at Bank of America Merrill Lynch, said in a note Tuesday.

Any large shifts out of money funds would risk meaningful disruptions to traditional intermediation channels, Cabana explained, adding that corporates and financial firms in the U.S. are beneficiaries of more than $1 trillion in existing prime fund investments.

Meanwhile, a report by economists at the World Bank in June last year concluded that negative rates led investors to pull cash from Europe and search for yield in developing economies. This might be a short term gain for these nations but could accentuate a downturn when policy is eventually tightened.

"Negative European interest rates may provide ongoing support to capital flows to developing countries and help reduce pressures from a gradual normalization of U.S. monetary policy, the report said.

"However, over the medium term, unsustainably low interest rates may render some countries more vulnerable to the eventual unwinding of exceptional stimulus measures in Europe and to a reversal of capital flows."

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