As President Donald Trump's trade war with China casts a pall over the global economy, the Federal Reserve is cutting official interest rates to stimulate activity.
But with the official U.S. rate currently set in a range of 2% to 2.25%, there's not much room to cut before the mark hits zero. Then what?
Fed Chairman Jerome Powell has discussed the option of resuming the unconventional "quantitative easing" policy that followed the financial crisis, the time when the official rate was cut to almost zero and the U.S. central bank started buying trillions of dollars of bonds to provide additional monetary stimulus.
But a new report from analysts at Bank of America, the second-largest U.S. lender, suggested that the Fed may instead have to cut rates below zero - a path that growth-challenged Japan has pursued since 2016.
According to the analysts, investors are now assigning "low but increasing odds the Fed will need to take rates to zero or potentially negative." They described the potential setup as a "Japanification scenario."
"We believe negative rates in the U.S. are a possibility," the analysts wrote.
The idea has gained credence recently among some top economists, including former Fed Chairman Alan Greenspan, who told CNBC that "it's only a matter of time" before U.S. Treasuries trade at negative rates.
It's a strange twist of the modern economic landscape and newfangled monetary policy, where the combined debts of governments, businesses and consumers keep increasing, but they pay ever-lower interest rates. Usually, more heavily indebted borrowers have to pay higher rates to compensate lenders for the heightened risk of a default.
When combined, Federal Reserve liabilities and total U.S. Treasury debt have more than doubled since the 2008 financial crisis to $26.3 trillion.
One problem with a new round of quantitative easing is that, at least in the past, such efforts have been designed primarily to drive down yields on bonds with distant maturities, such as 10-year U.S. Treasuries, to stimulate long-term borrowing and thus to rejuvenate investment and spending by businesses and households.
But yields on the 10-year U.S. government bonds are already at 1.46%, below the Federal Reserve's main rate, so further use of QE might only deepen the "inverted yield curve" that many investors already see as a sign of a coming recession. Usually, yields on short-term borrowings are lower than those for longer-term bonds, since investors historically demand additional interest as compensation for the higher risk of tying up their money for a longer period of time.
"On the surface, the Fed appears to have many options for unconventional easing," the Bank of America analysts wrote. "However, the Fed's easing playbook is somewhat curtailed if the yield curve remains flat."
Other concerns: Banks would likely face a severe squeeze on their profit margins, while pension funds might have trouble earning enough money to pay retirees what they're owed. And investors might start taking excessive risks to capture the higher returns they historically were used to - potentially leading to outsize losses or another financial crisis when economic conditions change for the worse.
Some economists say that 10-year Treasury yields are unusually low because the global economy is slowing, prompting investors around the world to buy U.S. government assets as a perceived safe haven for their money.
But another explanation is that yields on long-term government bonds from several of Europe's biggest economies - Germany, France, the Netherlands, Switzerland -- have already gone negative, in addition to those from Japan, according to FactSet.
Torsten Slok, chief economist at the German lender Deutsche Bank , estimated in a report last month that some $15 trillion of government and corporate bonds globally now carry negative yields, or 27% of the combined total outstanding. When U.S. bonds are excluded, the percentage rises to 45%.
Fitch, the bond-rating firm, wrote in a report last month that negative rates could be beneficial for the government since they would reduce annual interest payments, in turn helping to curb federal budget deficits that have ballooned to roughly $1 trillion a year since Trump's tax cuts in 2017.
The downside, according to Fitch, is that the interest rates "will ultimately rise again in the long term, making debt reduction a more acute policy challenge."
The Fed could cut the official U.S. rate by 0.25 a percentage point eight more times before hitting zero, known in monetary-policy jargon as the "zero lower bound."
According to the Bank of America analysts, investors in global bond markets are already anticipating five such reductions by early 2021.
"With only three remaining 0.25 percentage-point cuts left, it will not take too severe of a macro shock to get the Fed back to zero," they wrote. Under that scenario, "a Fed conventional easing cycle would be amplified by a significant portion of the developed market world also easing policy to at or below zero."
Which might simply push 10-year Treasury yields to new lows. And put pressure on the Fed to disregard the zero lower bound altogether.
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