Fed Likely To Implement Negative Deposit Rates

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 |  Includes: FCX, JNJ
by: Disruptive Investor

Summary

The Fed is likely to follow the ECB and introduce negative deposit rates.

The excess reserves of depository institutions with the Fed has surged to $2.5 trillion, and the Fed pays an interest of 0.25% on excess reserves.

A likely introduction of negative deposit rates can spur a further rally in stocks and bonds.

The ECB introducing negative deposit rates was another unusual policy measure the central banks have introduced since the beginning of the crisis. Negative deposit rates mean that banks will have to pay the ECB whenever they park excess cash with the Central Bank. This article looks into the reasons for believing why the Federal Reserve is likely to introduce negative deposit rates and its implications on the asset markets.

The primary objective of negative deposit rates is to discourage banks from keeping excess reserves with the central bank and to encourage lending. If this is the objective, the case for the Fed to introduce negative deposit rates is strong.

As the chart below shows, the excess reserves of depository institutions with the Fed is currently $2.5 trillion and the excess reserves have surged after the recession. The U.S. banks therefore find it safer to park the money with the Fed and earn a interest of 0.25% than to lend the money in an uncertain economic scenario.

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I completely agree with the bank's stance and it is natural to be conservative when the economic outlook is uncertain. Coupled with this, the consumers and businesses are borrowing relatively more slowly than the pre-crisis levels. In particular, the credit growth among consumers is dismal.

However, from the Fed's perspective and the mindset seen through the crisis, it is very likely that the Fed will try to boost lending by introducing negative interest rates on deposits soon.

I am also not sure if negative deposit rates will really help spur credit growth. My best guess is that negative deposit rates will help asset markets. Banks might park relatively less money with the Fed or ECB and use the excess reserves to generate positive returns from different asset classes.

This will make the bubble in equity markets bigger. However, the bond market might rally further in such a scenario. Also, higher level of speculation might be witnessed in industrial commodities and oil.

The bottom-line is that negative deposit rates can have unintended consequences, with the biggest feat being that bubbles in different asset classes can take gigantic proportions.

I have been of the opinion that equity markets are expensive and a steep correction is likely. However, I will have to change my opinion if the Fed does introduce negative deposit rates relatively soon. The markets, which in my opinion are overvalued, might rally further on any such policy measure.

Besides that, an increasing monetary base, as shown in the figure below, also supports asset markets. An increasing monetary base is an indication of accommodative policies by the Fed and the monetary base surge in the recent past has been very sharp, with the monetary base increasing by $1.4 trillion in the last 18 months.

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Both these factors point to equity markets moving to higher levels in the foreseeable future. There is no doubt that there is a high level of speculative activity in the markets and the margin debt data supports my point. As of April 2014, the margin debt was $437 million, which is close to all-time highs.

Considering these factors, I will remain invested in equities. However, it might be a good idea to book profits in stocks which have run-up too much and too fast. A high level of margin debt can trigger a deep market correction if sentiments get bearish at any point of time.

My idea would be to invest in low beta stocks and stocks that have not participated in the rally. The following stock ideas would come in that category -

Johnson & Johnson (NYSE:JNJ) - The Company has a low beta of 0.54 and is trading with a decent dividend yield of 2.7%. With the company's primary segments being consumer, pharmaceutical and medical devices & diagnostics, the stock is less prone to negative impact from economic downturns. In addition, JNJ has been increasing its presence in emerging markets where growth is more robust. At current times and market valuations, this is a good stock for the portfolio.

Freeport-McMoRan Copper & Gold (NYSE:FCX) - The Company has been moving sideways for nearly two years and is relatively undervalued as compared to industry peers. The stock also offers a good dividend yield of 3.6%. Growth in China might remain a concern, but my opinion is that FCX has seen the worst, and the company debt reduction plans along with key Brownfield expansion will result in better days ahead. The stock is a value buy and a good pick in an expensive market.

In conclusion, investors need to remain cautious as markets remain overvalued. However, the Fed might continue to introduce policies, which support markets at higher levels. In the near-term, negative rates on deposits is a likely policy introduction and can trigger further rally in stocks and bonds.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.