Time to Put the ‘Fed Put’ to Bed

As is its wont, the Fed managed to get everyone all riled up while doing nothing yesterday. It didn’t raise rates. It didn’t make further changes to its quantitative easing tapering, which remains on course to end in March. However, policymakers did cement expectations for a March rate hike, and market-based indicators now envision the Fed acting at every remaining meeting this year—despite January’s sharp negativity. The Fed’s apparent willingness to further expectations of tightening despite rocky markets is now fueling a new talking point: the apparent death of the so-called Fed Put, in which the Fed allegedly rescues falling markets with rate cuts or other measures “easing” policy. If the Fed is no longer willing to soothe investors with a monetary move, what hope do stocks have? Well, in our view, they have quite a lot of hope. This bull market was never dependent on Fed policy, and we question the entire existence of the Fed Put to begin with. We suspect it was always imaginary—a byproduct of investors’ bizarre Fed obsession. A bull market that overcomes short-term negativity and rate hikes could go a long way toward setting investors straight.

The legend of the Fed Put began in 1987, when Alan Greenspan’s Fed cut rates after the October crash known as Black Monday, creating the impression that the Fed was responding directly to—and seeking to aid—the stock market. People viewed it as a symbolic put option, which isn’t a great analogy if you understand how options contracts actually work, but the general belief that the Fed would put a floor under a falling market stuck.^[i] Pundits now write of the Fed stepping in during market “corrections,” implying the Fed routinely slashes rates when markets get rocky. Yet the only tangible evidence we see cited is their decision to cut rates in 2019, over half a year after late-2018’s correction ended.

A cursory glance at the fed-funds target rate’s history shows the Fed actually stands pat for most corrections, with cutting cycles typically arriving during bear markets. There was no magical Fed Put in the 2000 – 2002 or 2007 – 2009 bear markets—stocks basically rolled their eyes and kept on falling. 1989’s rate-cut cycle, which accompanied the Savings & Loan Crisis, didn’t prevent 1990’s bear market and the subsequent recession. As for bull market rate cuts, the mid-1990s cutting cycle started over half a year after 1994’s flat stretch ended, with the first cut arriving about halfway into a great 1995.

We see two occasions—and two only—where Fed cutting cycles corresponded with market lowpoints. The first is the aforementioned 1987, and we do think the Fed’s moves probably contributed to the recovery. But not because there was some huge impact on investor confidence, and not because stocks love rate cuts. Rather, that bear market started amid a global liquidity crunch. As Fisher Investments’ founder and Executive Chairman, Ken Fisher, observed in a Forbes column published that October 5, two weeks before Black Monday: “If there is so much liquidity floating around to fuel higher stock prices, then why the devil are interest rates rising? With excess liquidity, you would expect rates to be flat or down. Not so.”^[ii] Five-year rates had jumped more than two percentage points over the preceding six months, nearing 9%—and dwarfing rates’ current uptick. Ditto for the 10-year, which jumped from around 7% that January to over 10% by mid-October. Rate cuts were vital to unfreezing credit and ensuring banks and clearing houses could access liquidity as needed during a time of severe market stress.

Rate cuts’ role in late-1998 was similarly aimed at interbank liquidity. Then, the Fed cut in September, October and November, as stocks were reacting to the collapse and bailout of hedge fund Long-Term Capital Management (LTCM). At the time, everyone feared the fund, which got whacked by its positioning during the Asian Currency and Russian Ruble crises, would trigger a broader banking meltdown. Generally speaking, when people fear a banking contagion, interbank funding markets tend to tighten—even freeze in extreme cases—as all the players hoard liquidity. Cutting rates helped keep money moving, ensuring banks could continue meeting their regulatory obligations. In Congressional testimony, Greenspan put the risk of contagion from LTCM at less than 50%, making the rate cuts more a prophylactic than a necessity—and we don’t think they were necessary for stocks to bounce out of that brief correction. Maybe they helped sentiment some, but we think stocks would have rebounded either way.

In our view, the legend of the Fed Put is telling mostly about human nature. People love finding narrative threads and grand explanations—it is how the human brain makes sense of the world. People also seemingly love the bizarre idea the head of the Fed is somehow steering the US economy, in spite of the fact their choices only influence the hundreds of millions of decisions consumers, investors, business leaders and others make at the margin. Putting a human face in charge of the economy makes it seem less amorphic, although that is divorced from reality. And in drawing all these threads, people get blind to logical pitfalls like confusing correlation with causation. Zeroing in on the evidence that supports their view and shunning all the rest. Taking stories at face value without investigating the claims. Investing successfully, in our view, requires being aware of this possibility and making a concerted effort to always question the prevailing view—especially if it is the view you hear everywhere. More often than not, things “everyone knows” are more market myth than reality. And even if they aren’t myth, if “everyone knows” them, they give investors no edge.

As for stocks in the here and now, we don’t see any indication that the Fed delaying rate hikes (which is what the Fed Put would mean now, with rates basically at zero) is necessary. The yield curve isn’t hugely steep, but there is plenty of room between short and long rates. Banks have more liquidity than they know what to do with, which is one reason why deposit rates are so stubbornly low (and were during the last decade’s short tightening cycle). Fed words and actions may hit sentiment a while longer, as false fears often do, but we think just getting over the rate hike hump should help clear uncertainty. If the Fed raises rates and the economy doesn’t buckle, that should help folks get over it and get on with it. Hanging on through more market wobbles might not feel comfortable at times, but for those who need market-like returns over time to reach their goals, we think it is likely the most beneficial move.