The Reason Interest Rates Didn’t Go Negative in the US

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During the first six months of 2021, the interest rate on the 1-month treasury rate fell as low as 0%, the 6-month treasury rate fell to .02%, the 2-year treasury rate fell to .09%, the 10-year treasury rate fell to .93%, and the 30-year treasury rate fell to a low of 1.66%. Notice they never went negative despite all of the quantitative easing that the Fed did.

What happened? Why didn’t interest rates in the US go negative even though interest rates in Japan and Europe went negative.

A video from Richard Duncan’s Macro Watch Newsletter in the 2nd quarter of 2021 gives us the answer.

The reason interest rates in the U.S. didn’t go negative was because the central bank of the US, the Fed, didn’t allow them to go negative.

The Fed used two monetary tools to prevent negative interest rates. The first tool was the Fed paid interest on the reserves that the banks hold at the Fed and the second tool was reverse repos.

Tool #1 — Interest Paid on Bank Reserves

The banks bank at the Fed whereas you and me bank at banks like BOA, Chase, Citi, and Wells Fargo. The money that the banks hold at the Fed is called reserves.

The Fed paid an interest rate of .1% on these bank reserves. This put a floor under the interest rate because it discouraged banks from lending at an interest rate of less than .1% since the Fed’s chance of defaulting is close to zero, and it doesn’t make sense for a bank to lend to someone that has a higher chance of defaulting for a lower interest rate.

Tool #2 — Reverse Repos

Reverse repos allowed the Fed to essentially pay money market fund participants an interest rate of 0%. Money market funds are a big source of funding and liquidity. This financial asset is where most of the cash that you and me have sitting in our brokerage accounts is located.

In a repurchase agreement, also known as a repo, a party sells securities (usually treasury bills) and then buys them back at a later date for a slightly higher price. The difference in price is the interest rate. Repos are usually only overnight transactions, but they can be for a longer period.

A reverse repo is the seller side of the repurchase agreement. A repo is a form of lending and a reverse repo is a form of borrowing.

The Fed was the borrower. It used reverse repos to borrow money so it could pay 0% interest, which created a place for money market funds to put their money. This also acted as a floor to interest rates because, as mentioned earlier, it doesn’t make sense for a money market fund participant to lend to someone that has a higher chance of defaulting than the Fed for a lower interest rate.