The “Fed Put” Is Dead: Long Live The Fed!
The era of "quantitative tightening" has officially begun and it is proving a very difficult one for financial markets and many investors to digest.
This is a profound change and one that is causing a lot of people to re-examine their investing frameworks.
Helpfully, there was another Federal Reserve Open Markets Committee meeting this week and it provided the opportunity for investors (and humble newsletter writers) to examine some of the popular assumptions about the evolving battle with inflation and price stability.
First off, what actually happened?
Well, Jay Powell and the Federal Reserve had their May meeting this past Tuesday-Wednesday. On the second day they notified investors that they were raising interest rates (by 0.50%) and accelerating the sale of assets of the Fed's balance sheet (over $500 billion planned in 2022).
This was the largest hike in over 20 years and it is likely that meetings in June and July could also see 0.50% rises. Quite the shift!
What market assumptions have been wrong?
We would rather focus our fire elsewhere but, briefly, the big takeaway from the last six months seems to be that any knee-jerk responses to Jay Powell's press conferences have been consistently wrong.
Wednesday's strong relief rally in stocks was immediately reversed on Thursday with a dramatic decline that gave up all the gains and then some.
Here is the earlier chart again:
We wouldn't suggest it as a strategy per se but if you are going to expect anything, expect the reaction on the Fed meeting day to be a head fake these days.
What strategies have been right?
More correct has been the contention that the "Fed put" is toast.
This name comes from the options markets where a "put" is a type of contract that, when purchased, can protect investors against asset declines. The "Fed Put" argument held that by interfering in markets, the Federal Reserve provided similar protection and thereby ensured there was a floor underneath asset prices.
The way this worked in practice is that every time there was a certain amount of volatility and a declining stock market, the Fed would frequently step in, either verbally or with real action, and shore up investor confidence.
Over time, this achieved a profound shift. By nominally pursuing stable and safe markets, the Federal Reserve inherently protected investors against further losses by promising to ease policy and flood the market with liquidity.
What had begun as an implicit unintended consequence became over the years, an explicit assumption for far too many investors.
"In the Fed we trust" became the mantra.
In fact, these days there is an argument that the "Fed Put" has actually become a "Fed Call."
A call is another type of option contract, the inverse of a "put."
A call contract protects pessimistic investors against rising prices. Which goes to show how grim things are becoming. It now pays to be pessimistic, not optimistic about the stock market.
Why are people calling it a "Fed Call" these days? Well, as we have articulated before in this newsletter, because Federal Reserve must hike interest rates until inflation is under control they will be forced to disregard market declines, no matter how steep or serious.
Another way to put this is: For the first time in a long time, the US central bank is prioritizing Main Street rather than Wall Street.
This could be a good thing!
The US economy has been weighted towards rewarding financial assets for too long. Main Street (i.e.: regular Americans, most of whom do not own a lot of stocks) could use some support.
But it is evidently not a good thing for those who own financial assets (like stocks or are looking for a mortgage or even get paid part of their compensation in stock). The arrival of the "Fed Call" will also create a deep and perhaps almost desperate desire for a return of the past and knee jerk "Put" behavior.
Or, as one commentator sarcastically put it: