Futures Market Sees Negative U.S. Policy Rate by Early 2021

(Bloomberg) -- Traders are now pricing in the possibility that the U.S. central bank will cut its policy rate below zero, dragging the yield on two-year Treasuries to a record low.

Fed funds futures contracts extended their rally from earlier this week and prices for early 2021 contracts surged above 100, a level that marks the boundary to negative interest rates. The five-year Treasury rate also hit an unprecedented low as securities rallied across the curve and falling yields weighed on the dollar.

Federal Reserve Chairman Jerome Powell has consistently pushed back against the idea of taking interest rates negative, though Atlanta Fed President Raphael Bostic said Thursday the central bank will deploy its full arsenal to aid the pandemic-hit economy.

The Fed is currently targeting a benchmark rate of between zero and 0.25%, but Thursday witnessed mounting speculation across markets about the possibility of that heading lower. Eurodollar options -- commonly used as a hedge against Fed policy action -- covered a central bank policy rate as low as negative 45 basis points by mid-2021.

“I don’t believe Powell wants to go negative, but his ‘whatever is necessary’ attitude suggests it’s a possibility,” said Todd Colvin, senior vice president at Ambrosino Brothers in Chicago. “I wouldn’t fade it just yet. While it’s apples and oranges, oil going negative proved that anything is possible.”

The January fed funds futures contract reach a peak of 100.025 on Thursday in New York. That was a contract high and indicative of a policy rate of negative two and a half basis points.

The rate on the benchmark two-year Treasury, meanwhile, fell to around 13 basis points above zero, and the five year rate dropped to 0.29%, below its previous low from March.

The moves followed a tweet late Wednesday from DoubleLine Capital’s Jeffrey Gundlach warning that pressure will build for fed funds to go negative, a level that would be “fatal.” Other market commentators such as Harvard University‘s Kenneth Rogoff have also said this week that the Fed should drop interest rates to less than zero.

The previous record low for the two-year yield, 0.1431%, had been reached in September 2011 amid concern over Europe’s sovereign-debt turmoil and as the U.S. economy struggled to recover from recession. It was above 1% as recently as Feb. 28, but its decline accelerated as the Federal Reserve embarked on emergency rate cuts to help support the virus-affected economy.

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