For years, the U.S. has witnessed negative interest rates overseas while our country seemed impervious to this trend. Now there is legitimate fear this could become a reality here.¹

Over last six years, the European banking system has been crippled by reduced profits and increasing defaults. When negative rates remain consistent for many years, this reduces the spread banks make between lending and borrowing. Defaults have also increased because of an economic downturn, both resulting in erosion of profits in the Euro banking system.

Initially it appears as though negative rates are a gift, but long-term, the benefits are elusive and harm to the banking system is significant.

Executives at the biggest bank firms, and well as Christiana Riley, head of Deutsche Bank AG’s U.S. operations, have warned U.S. policy makers against going the route of European banks, which have suffered from below-zero rates since 2014. Nevertheless, banks are preparing for this reality by running internal numbers that show the drop in margins would grow incrementally as rates go further negative.

If Foreign central banks in Europe and Japan were to dramatically reduce yields on government bonds again to historic negative levels seen on March 9, 2020, the U.S. 2-Year Treasury would fall to zero yield, pressuring the Federal Reserve to temporarily reduce the Fed funds rate to a range of zero to -0.25%.

Despite the warning from abroad, the Fed might lower rates below zero if the right conditions unfold, including seeing leading central banks go negative that previously had not. In the short run this would be a good move, but benefits would erode after a year or two. Several years of negative rates would likely lower market valuations of banks to levels of those seen in Europe and Japan now.

The Fed has yet to enter a sub-zero policy-rate zone but yields of short-term maturities have been negative in the recent past. Negative rates, and the consequences for banks, are no longer a far-fetched scenario for the U.S.

1 - Source: bloomberg.com, Specter of Negative Rates Is Putting Wall Street Bankers on Edge

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