Negative Interest Rates & Their Impact On Financial Asset Prices

In an unexpected move very early this past Friday morning (Jan 29th), the Bank of Japan announced that it will cut the rate on current accounts that commercial banks hold with the BoJ to minus 0.1%, adding that it will push this rate even lower if necessary. With this move to a negative interest rate policy (NIRP), the Bank of Japan now joins a half dozen central banks in major countries across Europe with interest rates also below zero. 

When I was a fresh young student at the University of Chicago Graduate School of Business 40 years ago, interest rates below zero were thought to be theoretically impossible. However, here we are in the real world and clearly the impossible is now becoming commonplace. In recent Q&A's following scripted speeches, Federal Reserve Chairman Yellen and influential NY Federal Reserve President William Dudley both said that a negative interest rate policy here in the United States was possible if financial conditions deteriorate enough to warrant such action.

San Francisco Federal Reserve Bank President John Williams told reporters this past Friday that he now sees slightly slower growth, slightly higher unemployment, and about a tenth of a percent lower inflation this year than he had expected in December, when the Fed raised rates for the first time in nearly a decade. The Federal Reserve probably needs to keep U.S. interest rates lower for longer given headwinds from weak global economic growth, a stronger dollar and an unexpectedly sustained drop in oil prices, according to Williams."Standard monetary policy strategy says a little less inflation, maybe a little less growth ... argue for just a smidgen slower process of normalizing rates," Williams said. "We got a little stronger dollar, some mixed data on the economy, some weakness in (fourth-quarter U.S. GDP growth), all of those coming together kind of tell me that we probably need a little bit more monetary accommodation this year than I was thinking in the middle of December." 

All the "ducks" are starting to quack now! The hawkish views that were so "unanimous" following the Fed's interest rate hike in December have quickly receded to the point where almost no one expects more than a single interest rate hike from the Fed for the remainder of 2016, and voices can already be heard around the water coolers on Wall Street that the Fed might actually have to cut rates before year-end. And a 4th round of QE may also be a possibility now!

What does this mean for investors?

For U.S. equity prices, probably flat to higher over the rest of this year. Corporate earnings disappointments coincident with an economy on the verge of (or already in) recession will negatively impact share prices which will tend to offset any potential easing of monetary policy by the Federal Reserve.

For U.S. bond prices, Treasuries will probably represent a reasonable flight-to-safety option, and Treasuries will have scarcity value if talk of another round of QE escalates. Corporate bonds will be plagued by the stigma of  potential bankruptcies in the energy sector, but overall the better credits should do well.

For foreign exchange traders, the U.S. Dollar has been "king of the hill" for almost five years now. After bottoming out in May 2011, the U.S. Dollar Index is up 37% since then. When the BoJ "shocked" the financial markets this past Friday with a negative interest rate policy, the U.S. Dollar Index jumped about 1%. My own feeling is that Fed governors and other Fed presidents like Williams this past Friday will join in a united chorus of dovish speeches over the very near term which will knock down the U.S. Dollar in foreign exchange dealings over the next several quarters. And if QE4 is actually announced by the Fed, then the U.S. Dollar could plunge! 

What's left?

Oh yes, GOLD, precious metals, and related mining shares. I believe that the 4 1/2-year bear market in gold, silver, and related investments is over! Gold prices are already up 5.48% in 2016 (despite a stronger U.S. Dollar!), which far eclipses almost every other investment in terms of performance. The S&P 500 Index is down 5.07% so far this year, and most other major U.S. stock indexes are down even more. Among sector indexes, the NYSE Biotech Index is actually down 24.00% and the KBW Bank Index is down 12.62% year-to-date so far in 2016!

In the interest of full disclosure, my current allocation to precious metals mining shares is approximately 40% in the accounts I manage. This relatively high sector allocation is up from zero % to start the year.

If a picture is worth a 1,000 words, please take a look at the latest monthly chart of the Philadelphia Gold/Silver Stock Index (symbol XAU) which shows a monthly chart buy signal just triggered by my computer trading system for the first time in 18 years (since January 1998). A monthly chart buy signal was also triggered in the Major Gold Miners ETF (symbol GDX) this month (among other buy signals in gold and silver related mining shares).

Philadelphia Gold/Silver Stock Index (XAU) Monthly Chart with Computer-generated Buy & Sell Signals

Major Gold Miners ETF (symbol GDX) Monthly Chart with Computer-generated Buy & Sell Signals