By Gertrude Chavez-Dreyfuss
NEW YORK (Reuters) - Signals from the interest rate options market suggest investors increasingly believe U.S. rates will turn negative this year, as the economic fallout from the coronavirus threatens to push the Federal Reserve into territory it is keen to avoid.
Rate options are implying a 26% probability that the key federal funds rate will go below zero by the end of December, according to BofA Securities data, citing short expiry options on one-year U.S. swap rates late on Wednesday. That compares with a 5% probability in early January.
The options measure the expected near-term movements of rates on interest rate swaps, derivatives that are sensitive to monetary policy expectations and used by investors to express views on where borrowing costs will go.
"Given the diminishing Fed toolkit, you always have to assign some probability to a negative interest rate policy" to fight the economic fallout of the coronavirus outbreak, said Bruno Braizinha, interest rates strategist at BofA Securities in New York.
The Fed funds rate has ranged from 1.0% to 1.25% after the central bank delivered a rare 50-basis point rate cut last week between regular meetings. It has never gone below the 0% to 0.25% band, and Fed officials have said they oppose negative rates, which have had mixed results in Europe and Japan.
Still, the twin shocks of the accelerating outbreak and recent tumble in oil prices have convinced some investors that negative rates may be hard to avoid, especially if a coronavirus-related slowdown badly damages the U.S. economy in coming months.
The S&P 500 index (SPX) and Nasdaq composite index (IXIC) cratered into bear market territory on Thursday as President Donald Trump's shocking ban on travel from Europe intensified fears of a global recession on the back of the coronavirus pandemic.
Treasury yields have plummeted to record lows in recent days, as investors rushed for shelter in U.S. government bonds and other safe havens.
Fed funds futures on Thursday implied traders saw a 100% likelihood that the central bank's benchmark overnight lending rate will fall at least another 75 percentage points at next week's Fed monetary policy meeting.
"It seems like we're going in the direction of negative rates," said Erik Bregar, head of FX strategy at Exchange Bank of Canada in Toronto, adding that the Fed seemed to have used up all its ammunition.Amrut Nashikkar, interest rates strategist at Barclays (LON:BARC) in New York, cited a "dramatic pick-up" in trading using swap rate options for strikes or target price levels that imply a negative fed funds rate.
"This is a big change from what we saw a couple of months ago," he said. "There were almost no (such) trades earlier this year."