Bond market, Yellen face off on negative interest rates

Yellen says gradual interest-rate hikes are possible, but market sees increasing likelihood of negative rates

These are puzzling times for investors: Federal Reserve Chairwoman Janet Yellen says U.S. interest rates could rise gradually, but another measure shows expectations of negative interest rates are rising.

The Fed raised interest rates two months ago for the first time in nearly a decade and signaled that rates could rise another four times this year. But that was before turmoil in financial markets that has sent the S&P 500 index SPX, +1.10% skidding more than 9% this year through Tuesday.

While Yellen emphasized in testimony before the House Financial Services Committee on Wednesday that monetary policy isn’t on autopilot, Treasury yields continued to slide toward session lows as she answered questions.
Indeed, the bond market is showing a higher probability for negative interest rates by the end of 2017, even as Yellen insisted that gradual rate hikes through 2017 are still on the table.

With major central banks across the world adopting negative rates—the Bank of Japan being the most recent one, in January—the market’s view has recently shifted to increasing expectations that the Fed would consider adopting a similar policy, Mark Cabana, rates strategist at Bank of America said in a note Wednesday.

As the following chart shows, expectations for negative U.S. interest rates has been rising since the beginning of the year.

Bank of America
The market-implied probability of negative rates by the end of 2017 has recently increased.
Asked if the Fed has the authority to enact negative rates, Yellen said it remains an open question.

But she said that although the legal issues surrounding negative rates haven’t been vetted, she isn’t aware of anything that would stop the Fed from pushing rates into negative territory if policy makers thought that was necessary.

Some economists think the Fed would face a firestorm of criticism if it adopted negative rates, as it has already been pilloried for hurting savers with its policy of ultralow interest rates.

Ultralow Treasury yields also have already been blamed for a recent rout in the bank sector XLF, +0.88% which recently plunged to their lowest level since October 2013. Low Treasury yields mean banks earn less from funding longer-term assets, such as loans, with shorter-term borrowings.

As the following chart shows, the 10-year Treasury yield TMUBMUSD10Y, +0.49% the Treasury market’s benchmark, has dropped more than 50 basis points since the beginning of the year amid selloffs in the stock market and tumbling oil prices, hovering on Wednesday around its lowest level in a year.
The benchmark 10-year Treasury yield has tumbled recently to its lowest level in a year.
At the same time, the yield differential, or spread, between long- and short-term Treasurys has been steadily shrinking. The difference between the benchmark 10-year TMUBMUSD10Y, +0.49% and the 2-year TMUBMUSD02Y, +3.44% Treasury note on Tuesday hit its lowest level since the Great Recession at 104.33 basis points.
The spread between long- and short-term Treasurys is at its narrowest since the Financial Crisis.
In other words, investors demanded a yield premium of just above one percentage point to loan money to the government for 10 years instead of just two. This phenomenon is known as a flattening yield curve and, according to analysts, it’s flashing warning signs about U.S. economic growth.