This is the clearest sign yet the Fed is moving towards negative interest rates

The Dodd-Frank Act requires the Fed to conduct yearly “stress tests” on major banks. They do this by giving the banks a set of hypothetical economic scenarios.

The Fed released this year’s scenarios on January 28. The “severely adverse” scenario instructed banks to test their systems for a deep recession, a 10-year Treasury yield as low as 0.2%, 5-year notes yielding 0%, and a -0.5% 3-month T-bill yield from Q2 2016 through 2019.

Is this “severely adverse?” It’s far less adverse than what Japan has already experienced. BOJ purchases have driven Japanese government bond yields negative 10 years out the curve.

Rates are also negative far out the yield curve all over Europe, even in countries that don’t deserve such rates—let alone midterm rates with even a one or a two handle.

That’s the Fed’s Message

The stress test scenarios aren’t a forecast, per se, but they mean the Fed at least sees those conditions as possible. The whole exercise is pointless if the scenarios could never happen. I think this stress test scenario is the clearest sign yet that the Fed views NIRP as a legitimate alternative.

It doesn’t mean NIRP is guaranteed. I believe Yellen when she says their policy is “data-dependent.” They are no more prescient about the future than the rest of us are. All they can do is look at the data and try to respond appropriately. I don’t envy them that job.

I think the Fed is currently in a position where negative rates seem like a reasonable solution. They see their last big move as not having had the desired effect and are considering a new set of options. NIRP is on their list.

Having decided to put NIRP on the list, the Fed has to make sure the banking system can handle it.

Whether it can is far from clear right now. The technology issues alone could unleash chaos if the Fed went negative without warning.

I think putting negative rates in the stress test scenarios is the Fed’s not-so-subtle message to Wall Street: “Get ready; this could really happen.”

How to Protect Your Wealth in a Negative Rates World

Gone are the days where you could earn a decent interest on traditional “safe haven” investments like CDs, money market, and savings accounts. Watch Mauldin Economics’ editors Tony Sagami and Jared Dillian discuss how you can protect and grow your wealth throughout the grand monetary experiment of negative rates.

The article was excerpted from Thoughts from the Frontline.

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