Where is the Fed put?
That’s the question on the minds of market participants who have forgotten what it’s like to operate in an environment where they are not the co-author of the monetary policy script.
Going back at least to September 2015, Fed policy was shaped by a two-way communication loop with the market. The Fed only moved with the market’s implied consent. That setup was the key determinant in encouraging the proliferation of the short vol. trade.
That communication loop helped transform “buy the dip” from a derisive meme about retail investors into a virtually infallible trading “strategy.” It become a self-fulfilling prophecy. Markets became so conditioned to policymaker intervention and dovish forward guidance that no one saw any utility in waiting around for it anymore. After all, if you know it’s coming, why wait on it? Why not buy the dip now?
Once that mentality took hold, it obviated the need for further dovishness. Markets reacted to the expectation of dovishness and in doing so, ensured the policymaker “put” ran on autopilot.
Traders were buying the prospective dip.
That came to an abrupt (if predictable) end when Jerome Powell took the reins. His data-dependent lean rebuilt the wall between the Fed’s decision calculus and the market; investors are no longer consulted, only the data matters.
Given that, the Fed put will now only come into play when a decline in equities manifests itself in an acute tightening of financial conditions.
Last Thursday, we brought you some excerpts from the latest on this by Deutsche Bank’s Aleksandar Kocic, who last week documented the re-re-striking of the Fed put – the second “re” there refers to October as the second effort in this regard, with February representing the first.
Fast forward a week and the conversation has become more relevant following a session that saw the Nasdaq fall by the most since 2011.
As documented over the weekend, the issue for equities in the context of the data-dependent Fed is that despite the stronger dollar and rising risk-free rates, financial conditions remain loose. In fact, Goldman’s Financial Conditions Index hit a record low (i.e., record easy) in January of this year just as the S&P hit a record high (note that the right scale is inverted):
Goldman’s U.S. FCI is just a weighted average of the policy rate (target Federal Funds Rate), a long-term riskless bond yield (10Y Treasury yield), a corporate credit spread (iBoxx domestic non-financials BBB 15Y+/10-year Treasury yield spread), an equity price variable (the S&P), and a trade-weighted exchange rate (in this case, Goldman’s trade-weighted exchange rate index).
As you can see from the fact that the white line on the chart is still some ways off from where it was at the beginning of, for instance, 2016, there’s an argument to be made that President’s Trump’s characterization of the Fed as “so tight“, is a bit of a stretch.
Until stocks fall enough to tighten financial conditions materially, there is no “Powell put”. Underscoring that is BNP, who, in a noted dated Tuesday, reinforces the notion that it now all depends on the read-through of the selloff for financial conditions and, by extension, for the real GDP impulse.
“Equities remain up on the year, corporate spreads are relatively compressed, fed funds is below neutral, and there remains ample liquidity”, the bank writes, on the way to stating the obvious, which is that “all told, broader financial conditions remain accommodative.”
The bank goes on to contrast the “good” old days, with the Powell regime. “The S&P declined by 12% over the first two months of 2016 as fears of a China hard landing mounted and the US growth outlook soured [causing] the Fed to pause in March 2016 and change their forecast from four hikes in 2016 to just two”, BNP writes, recounting how things used to work under Yellen.
That marks a rather stark contrast with the XIV blowup. “An XIV scare in late January of this year drove the S&P500 down by just over 10% [but] this time around, the FOMC’s gradual pace of rate hikes went undeterred as the economic outlook remained promising with the positive impact from expansionary fiscal policy still in the pipeline,” BNP reminds you (as if you needed a reminder).
So when does the Powell put kick in? Well, for BNP the answer is 200 S&P points from where we are on Thursday morning. “In light of recent market moves, the Fed is likely to reassess broader financial conditions”, the bank says, before concluding that in their view, “if financial conditions move closer to neutral (i.e, S&P near 2500), the Fed could pause its rate hike plans.”
That would be 7% lower from Thursday morning’s levels and ~15% from the late September highs.