The Fed Could Be Next: Negative Interest Rates And You

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Includes: DIA, IWM, QQQ, SPY
by: Peter Newell

Summary

The Fed has asked banks to prepare for the possibility of negative interest rates, possibly to prepare everyone for an eventuality.

With much of Europe and Japan already negative, the Fed seems to be considering this as a real option to stimulate economic growth through monetary policy.

From what we've seen so far, the real effect of negative rates are negative yields on bonds and the possibility of banks charging depositors.

With the expected volatility to come from the Fed's next few decisions, now might be a good time to start learning about options.

Another option would be to stash cash in gold, but that's a bit of a one trick pony.

Wow, maybe the Fed has some kind of personality disorder. I remember a little more than two months ago they raised rates alongside a bullish, everything-is-fine speech by Yellen. Now they've asked banks to add the effects of 'possible' negative interest rates to their stress tests to see how it would affect the banking system as a whole. This is being touted as a 'just-in-case, what-if' scenario, but the writing seems to be on the wall. With the global economy going to hell in a hand basket, the Fed seems bent on making things worse. The question is: how do we prepare for this and what steps should investors take if this does happen?

Negative interest rates: what are they?

In theory, when a central bank lowers deposit rates into negative territory, banks have to pay the central bank interest on their excess cash. In economic theory, this should encourage banks to lend money at ever cheaper rates, stimulating business investment, infrastructure, consumer spending or some combination of these. Negative rates are a drastic measure by central banks with no other alternatives left to stimulate economic growth through monetary policy.

So do they work?

Short answer? We're not 100% sure. They're a newly deployed tool by central banks in Europe and Japan. I'm of the opinion that monetary policy, or supply-side policy, cannot fix a demand-side problem. To be frank there are a lot of problems in the American, and global economy, and negative interest rates are probably not going to boost economic growth the way central bankers would like.

What we do know about negative interest rates so far, is that they can lead to banks passing along the added cost of doing business to depositors, and they can cause bond yields to go negative as well. So there if the Fed does pull the trigger on negative interest rates, amongst other calamities, it is possible for already low bond yields to go negative; and your banks and brokers could charge you for holding cash at their institutions.

Of course there will be banks willing to lend out copious amounts of money to businesses and consumers to avoid some of the cost of negative rates. But businesses already seem wary of taking on more risk, and extending a lot more credit to an already indebted society sounds like a bigger disaster in the making.

So what should investors do?

Well, the instinctive response would be to hide. But hide where? You might end up paying the bank to hide in cash. Bonds could easily become negative yielding, probably shouldn't hide there. The equity markets responded pretty poorly over the last Fed hike, and investors still put a lot of weight into the Fed's words and actions. So if they pulled the trigger and went negative expect much higher volatility in the stock markets. So again, we probably don't want to hide there either.

So that narrows it down a little bit. I think that leaves us with, in terms of liquid assets; precious metals, options, and commodities. Commodities are an interesting idea, but the fundamental factors (supply & demand) that led to their currently depressing prices won't change because the Fed goes negative.

For some investors, gold and silver might be the ticket and I can't argue with the idea that they will always hold some intrinsic value. There is a risk with gold that it has lost its glitter and investors no longer see it as a safe-haven. But I can still see a majority of investors turning to gold as the safest of all options if Federal interest rates turn negative, simply because gold isn't directly affected by interest rates.

The best option might be options

The last option might be the most appealing to equity investors with a solid grasp of option strategies. Options are inherently risky, but if you know what you are doing with them, there are several powerful, volatility-driven strategies that can be deployed to profit from increased or decreased volatility. Furthermore, these strategies can be applied over many different time frames and can be bought or sold on most ETFs, stocks, currencies, metals, commodities, and indices.

Options thus give investors with adequate knowledge and discipline an avenue to stay in the market, and generate profit, while mitigating risk from severe, event-driven volatility like the one being explored by the Fed now.

Disclosure: I am/we are long GLD.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.