Negative Interest Rates: What You Need to Know

INVESTMENT PERSPECTIVES Negative interest rates: What you need to know

Negative policy rates haven’t U.S. money market funds, with $5 If negative policy rates were proven to be an effective trillion in assets, are systemically implemented, constant net asset policy tool. important and present a potential value (NAV) money market funds deterrent to negative policy rates. would need to find a way to accommodate them.

The Fed is unlikely to implement a negative interest rate policy (NIRP).

We believe the Federal Reserve (Fed) will not lower interest rates below 0% in the near term because it has said as much on many occasions. The current federal funds target Jeffrey Weaver rate between 0.00% and 0.25% is the Fed’s managed policy rate. However, negative Senior Portfolio Manager, Head of yields on short-term Treasury securities can and do occur in such a low interest rate Municipal and Short Duration Fixed environment based on supply and demand dynamics or risk-on/risk-off sentiment. Income, WFAM Global Fixed Income While money market funds can manage such temporary dislocations, a negative Fed interest rate policy will influence overall yields, not just short-term Treasury yields.

The Fed has said it does not intend to implement a negative interest rate policy Laurie White Fed Chair Powell said on May 13, 2020, that “negative rates are not something Senior Portfolio Manager, we are looking at.”1 Instead, the Fed has used tools such as quantitative easing, Taxable Money Market Funds, WFAM Global Fixed Income various forms of credit support, and forward guidance during the coronavirus crisis. Communication, or forward guidance, is especially important in helping set expectations about the economy, inflation, and interest rates for investors, households, and businesses. In an assessment of negative target rates, Chair Powell said, “forward guidance and asset purchases work” while “evidence on the effectiveness [of negative rates] is very mixed.”2 The Fed has emphasized this view many times as market conditions and market strategists have brought this issue to the fore.

1. and 2. Peterson Institute for International Economics virtual event, May 13, 2020. July 2020 Reasons the Fed prefers not to markets to a much larger extent than the European system does. U.S. money market funds total $5.1 trillion, over which have a NIRP $4.3 trillion is in constant NAV government and retail prime and municipal money market funds. The size of the A NIRP has several drawbacks that make it unsuitable for European money markets is a fraction of the size at only use in the U.S. at this time, according to Fed Chair Powell. €121 billion.4 In a May 29, 2020, online conversation with First, the benefit of a NIRP in meeting its goal is mixed. former Vice Chair of the Fed Board of Governors Alan For example, the European Central Bank (ECB) embarked Blinder, Chair Powell reiterated that U.S. money market on a negative interest rate policy beginning in June 2014, funds are systemically important. Not only are money intending to boost inflation to just below 2% by spurring market funds a significantly viable solution for institutions lending. But so far we’ve seen only modest improvements. and individuals to invest their money, they are also an Many are wondering if this modest improvement is worth important source of funding for corporations, municipalities, the long-term damage to savers, including pension funds. and other issuers of short-term debt. Chair Powell added that, in the U.S., we have institutional arrangements that Eurozone inflation has struggled to remain near 2%, the would not work with negative rates. As a result, we believe ECB’s target for price stability. the effect on money market funds would be an important 3.5 consideration against setting a NIRP.

3.0 2.5 Reasons the Fed may eventually 2.0 decide to use a NIRP 1.5 To be fair, the Fed didn’t rule out the possibility that 1.0 circumstances might cause it to reassess the role of negative 0.5 rates as a policy tool. For instance, the Fed could decide

Year-over-year percent change percent Year-over-year to use a NIRP if growth or inflation trends deteriorated 0.0 significantly. So far, other tools such as quantitative easing -0.5 and specific asset purchases have been seen as a more -1.0 targeted way to help the economy and financial system. 2012 2013 2014 2015 2016 2017 2018 2019 2020 The Fed prefers to use tools that it has successfully used Inflation, U.S. consumer prices—all items Inflation, euro area consumer prices (harmonized)—all items before—including communication—rather than negative rates. In addition, with one of the Fed’s monetary objectives Sources: Eurostat and U.S. Bureau of Labor Statistics. Retrieved from fred.stlouisfed.org. Data as of May 2020. being stable inflation, the risk of very low inflation or outright deflation for an extended period could prompt the Fed Second, it is unclear what effects negative rates might to implement a NIRP. Here, real rates matter. If deflation have on the willingness of financial intermediaries to lend happens, a positive nominal rate can be overly tight for and on the spending plans of households and businesses. the economy—the nominal rate would have to follow the Among concerns cited by Fed Chair Powell is the question negative inflation rate down to keep monetary policy from of whether negative rates create downward pressure being contractionary. on bank profitability, and thus limit credit expansion. Negative interest rates interfere with the process of credit The experience of other countries shows mixed success intermediation by impeding the basic function of banks: using NIRP to stabilize inflation. Sweden’s Riksbank cut its to take deposits and make loans, thereby facilitating the repo rate below zero in 2015 to reduce the risk of deflation. transfer of funds to various productive activities In this way, the policy worked because Sweden’s inflation via investors. rate reached the 2% target rate in 2017 and the central bank returned to a zero-rate policy in 2020. Third, the U.S. financial system is considerably different from countries that have adopted negative interest rate policies, and “negative rates could have more significant adverse effects on market functioning and financial stability here than abroad.”3 The U.S. financial system relies on money

3. FOMC minutes from October 29–30, 2019 4. Crane Data as of May 31, 2020 2 Constant NAV funds and the effect of negative rates Exhibit A: Hypothetical example of a reverse distribution mechanism In the current environment, as rates approach zero, money market fund sponsors may have to waive fees to support The mechanics of RDM, also known as share a zero or net positive yield. This happened after the 2008 cancellation, can be thought of as the opposite of financial crisis when the federal funds rate was maintained at daily dividend accruals but pertaining to the number a target rate of 0.00% to 0.25% for over seven years starting of shares rather than the value of accrued income. in December 2008, and it’s beginning to happen again now Every day that the fund posts a negative net yield, that the federal funds rate is again at the zero lower bound. a small portion of shares equivalent to the daily However, in the scenario where the Fed implements a income shortfall is deducted from a shareholder’s negative interest rate policy, a money market fund would not account. The example below assumes a one-year be able to maintain a positive net yield through fee waivers holding period with no additional transactions. when the fund’s gross yield is negative. Key assumptions: In that case, if money market fund gross yields were Annualized yield is -0.50% negative, floating NAV money market funds (institutional Beginning shareholder assets = $100 million prime and municipal money market funds) would not be affected because the fluctuating NAV would incorporate the Beginning shareholder shares = 100 million impact of the negative yield. However, constant NAV money After one year: market funds, such as government and retail prime and municipal money market funds, would need a way to pass on Number of shareholder shares = 99,500,000 the negative yield to shareholders. Under current regulations Value of shareholder assets (at $1.00 per share) = today, fund sponsors would need to convert a constant NAV $99,500,000 money market fund into a floating NAV structure because it’s the only option currently allowed under the U.S. Securities This method—canceling shares using RDM—had and Exchange Commission (SEC) rules. been used in Europe to account for negative yields in its euro-denominated constant NAV funds prior The industry—including the SEC, the Investment to the implementation of money market reform in Company Institute, the IRS, and money market 2019 that prohibited this practice. providers—is working to develop and agree on a method for accounting for negative yields in constant NAV funds. One possibility that seems to be gaining traction is a reverse distribution mechanism (RDM) that would pass negative yields to shareholders by reducing shares in a shareholder’s account equivalent to the shortfall in income. The fund’s NAV would remain at the constant $1.00 NAV, but an investor’s shares would be reduced to incorporate the effect of the negative yield.

3 Summary The Fed has emphasized many times that it does An inside look at not believe negative interest rates are necessary managing portfolios right now. Fed officials have also said that they prefer to use proven monetary policy tools and that they when rates are cautious about the potential negative effects are negative of implementing a NIRP, including harming banks’ profitability and thereby countering their effort to spur lending. In Europe, policy rates and market yields are negative. The ECB policy rate (the interest rate While we don’t believe the Fed wants to use a NIRP on the deposit facility) is -0.50% and, as an anytime soon, the money market industry has begun example, a 2-year German government bond discussing ways to handle negative interest rates. yield was -0.61% as of June 4, 2020. We’ve asked RDM is one possibility gaining increasing traction. Henrietta Pacquement, senior portfolio manager Implementation of RDM would likely require a long lead and head of investment grade - Europe for time for service providers to develop and implement WFAM, her perspective of negative rates. a method of accounting for negative yields, for fund companies to create the necessary systems to handle Q: Henrietta, as a bond fund manager, what’s the change, and for boards of directors to approve the most notable about the effects of negative changes and update required prospectus disclosures. interest rate policy in Europe?

Negativ e yields in Europe have had the desired As yields approach zero, money market fund providers A: effect of pushing money into riskier assets and may need to waive fees to keep net yields at least more productive parts of the economy. However, at 0%. Meanwhile, the money market fund industry while European investors have had to increase is exploring ways to account for negative yields in a their risk profile to meet investment targets, the money market fund, should a NIRP become a reality. effect has been tempered by overall risk tolerance, But a negative interest rate policy by the Fed is a bridge regulation, and subdued growth prospects. In that we do not expect to cross anytime soon. addition, there has been a degree of leakage, as European investors have been seeking yield outside the euro complex, in the U.S. corporate bond market for instance. Meanwhile, the effects on banks, insurance companies, and pension funds have been mixed.

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l In addition, a total return calculator is available on our website to help investors understand how the yield and NAV movement of floating NAV MMFs versus stable NAV MMFs could affect returns.

For government money market funds: You could lose money by investing in the fund. Although the fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. An investment in the fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The fund’s sponsor has no legal obligation to provide financial support to the fund, and you should not expect that the sponsor will provide financial support to the fund at any time. For municipal income funds: A portion of the fund’s income may be subject to federal, state, and/or local income taxes or the alternative minimum tax. Any capital gains distributions may be taxable. For floating NAV money market funds: You could lose money by investing in the fund. Because the share price of the fund will fluctuate, when you sell your shares they may be worth more or less than what you originally paid for them. The fund may impose a fee upon sale of your shares or may temporarily suspend your ability to sell shares if the fund’s liquidity falls below required minimums because of market conditions or other factors. An investment in the fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The fund’s sponsor has no legal obligation to provide financial support to the fund, and you should not expect that the sponsor will provide financial support to the fund at any time. For retail money market funds: You could lose money by investing in the fund. Although the fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. The fund may impose a fee upon sale of your shares or may temporarily suspend your ability to sell shares if the fund’s liquidity falls below required minimums because of market conditions or other factors. An investment in the fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The fund’s sponsor has no legal obligation to provide financial support to the fund, and you should not expect that the sponsor will provide financial support to the fund at any time. Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses. Carefully consider a fund’s investment objectives, risks, charges, and expenses before investing. For a current prospectus and, if available, a summary prospectus, containing this and other information, visit wellsfargofunds.com. Read it carefully before investing.

All investing involves risks, including the possible loss of principal. There can be no assurance that any investment strategy will be successful. Investments fluctuate with changes in market and economic conditions and in different environments due to numerous factors, some of which may be unpredictable. Each asset class has its own risk and return characteristics. The views expressed and any forward-looking statements are as of June 22, 2020, and are those of Jeffrey Weaver, senior portfolio manager, head of Municipal and Short Duration Fixed Income, WFAM Global Fixed Income; Laurie White, senior portfolio manager, WFAM Global Fixed Income; and/or Wells Fargo Asset Management. Discussions of individual securities, or the markets generally, or any Wells Fargo Fund are not intended as individual recommendations. Future events or results may vary significantly from those expressed in any forward-looking statements; the views expressed are subject to change at any time in response to changing circumstances in the market. Wells Fargo Asset Management disclaims any obligation to publicly update or revise any views expressed or forward-looking statements. Wells Fargo Asset Management (WFAM) is the trade name for certain investment advisory/management firms owned by Wells Fargo & Company. These firms include but are not limited to Wells Capital Management Incorporated and Wells Fargo Funds Management, LLC. Certain products managed by WFAM entities are distributed by Wells Fargo Funds Distributor, LLC (a broker-dealer and Member FINRA).