Is the Fed Put Kaput?

The Fed Put and Accommodative Monetary Policy Tools

For a number of years, equity investors assumed that the Fed would pull back short-term interest rates whenever equity markets substantially sold off.  Early in this century, investors labeled this action the Greenspan Put.  Since the great recession, the very accommodative monetary policy tools—zero interest rate policies (Z.I.R.P.) and quantitative easing (Q.E.)—broadened the sense of the Fed Put.

Monetary Policy Tools Reversed—What Changed?

At the end of 2015, the Federal Open Market Committee (F.O.M.C.) moved from very accommodative monetary policies to a gradual normalization.   As a result, and for the first time since 2006, the F.O.M.C. raised the Fed Funds rate from “zero” to 0.25-0.50%.  Since then, the F.O.M.C. raised Fed Funds rates five more times—most recently to a range of 1.50-1.75%.

Then in 2017, a second monetary policy reversal occurred. The Fed flipped from quantitative easing to quantitative tightening (q.t.)  the ultimate goal of Q.T., over the next two years, will be to reduce the Fed’s balance sheet from over $4 trillion to $2.5-3.0 trillion.  As a result, by this time next year, the Fed will likely be shaving its balance sheet by $50 billion monthly or $600 billion annually—not a small haircut.

What Does History Tell Us?

No history exists to judge the impact of quantitative tightening.  Not only that, no history exists to further judge the complexity of simultaneously reversing these two monetary policy tools—Z.I.R.P. and Q.E.  In our view, investors remain somewhat complacent about the impact of these two important changes in the use of monetary policy tools. Need investors be reminded about their recent complacency concerning low stock market volatility?

What Does Normalizing Monetary Policies Mean for The Fed Put?

On a day (4/6/18) when the markets reacted very negatively to both trade war headlines and a soft jobs report, Fed chair Jerome Powell spoke to the Economics Club of Chicago.  In the past, investors expected a Fed chair to acknowledge such events and perhaps give some glimmer of Fed counter moves if such turmoil continued—the so-called Fed Put.  No hope came forth in his speech.  Instead, he commented that the recent increase in the Fed funds rate “marked another step in the ongoing process of gradually scaling back monetary policy accommodation.”  Is there no hope for a future Fed Put?

Is the Fed Put KaPut?

A recent study by economists at the business schools at Duke and the University of California-Berkeley titled the economics of the Fed Put suggests hope exists.  They define the Fed Put as: “the combined effect of the Fed reacting to the stock market and the Fed affecting the stock market.”  In their study, they show that: “the explanatory power of the stock market for changes in the Federal funds target is stronger than that of any of the 38 macro variables covered by Bloomberg.” They reason that the Fed responds to a major decline in the equity markets because of its potential negative effect on consumption and capital spending.  Bottomline, we have the classic chicken and egg question.

What Will Bring Back the Fed Put?

Their study suggests that the Fed Put will likely return when events provide a powerful negative effect on the financial markets.  For example, this quote from the latest F.O.M.C. minutes offers such a possibility: “a strong majority of the participants viewed the prospect of retaliatory trade actions by other countries, as well as other issues and uncertainties associated with trade policies, as downside risks for the U.S. economy.”  With such an event, those concerns might lead the F.O.M.C. to curtail further Fed fund rate increases and take other actions.  The Fed Put would then return.

Investment Conclusions

Does the economics of the Fed Put study refute the classic investment adage written in stone on Mt. Sinai—don’t fight the Fed?   Perhaps, but our own experience suggests not.  With no change in direction, we continue to expect the more restrained Fed policies to begin influencing financial markets around year-end and the economy in 2019.  This affect would likely cap market valuations, at best, or move them lower.  This change would force even greater focus on earnings growth.  At present, investors can find such growth in selected stocks and funds in both the U.S. and non-U.S. markets.   As the F.O.M.C.  continues to reduce monetary policy support, higher interest rates will likely result.  With that as a possibility, investors should look to short-term fixed income paper as well as alternative products to substitute for some of their traditional long-term note/bond investments.

Andrew J. Melnick, CFA
Chief Investment Strategist

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