The market thought the “Fed Put” was over. But its revival is looking increasingly likely.
What is the Fed thinking? That's when the Federal Reserve signals interest rate cuts if the economy or financial markets collapse. This concept originated in his 1980s and his 1990s, when the market began to expect the Fed to intervene during times of financial market stress, causing stock market gains.
The phrase originates from the options market, where investors can hedge their bets on stocks and bonds by purchasing insurance on them. However, investors do not need to buy Fed puts. It existed implicitly and provided reassurance whenever the market was overly depressed.
Puts work well when inflation is moderate and growth is the focus, as was the case for most of the 40 years leading up to the end of the pandemic. This policy works less well if inflation is a problem and the Fed is created to balance maintaining the economy with controlling inflation. That was one reason why Fed puts were nowhere to be seen during the 2022 bear market. The Fed's goal was to fight inflation, not promote growth.
However, comments from last week suggest that puts may be on the way back. To be sure, the central bank kept the federal funds rate unchanged at between 5.25% and 5.5%, but Fed Chairman Jerome Powell said in a press conference that all options for future monetary policy are on the table. The Fed's official statement on interest rates reads:
Advertisement – SCROLL TO CONTINUE
“In assessing the appropriate stance of monetary policy, the Committee will closely monitor the impact of future information on the economic outlook.'' This means that if inflation rates are low enough, there is a willingness to cut interest rates. It means something. “If risks materialize, the Committee stands ready to adjust its monetary policy stance as appropriate.”
That's a balanced statement and rightly so. Inflation has fallen from its post-pandemic peak but remains above the Fed's 2% target, and growth is strong but slowing. As a result, the Fed will need to keep interest rates on hold for some time. But it also signaled that Chairman Powell is prepared to cut interest rates if economic conditions warrant it.
Yes, today's puts are very different from the puts used during the disinflationary era of the 1990s, 2000s, and 2010s. After that, with nothing expected to push inflation and economic growth above low single digits, the Fed became aggressive in sending strong signals to the market that it was prepared to cut rates. Now that inflation is a more entrenched part of the economy, Powell's put may seem less obvious. Nevertheless, a mild form of the Fed's put is better than no put at all.
Advertisement – SCROLL TO CONTINUE
“That's one of the reasons I'm pretty positive about the market in the second half of this year,” said Rhys Williams, chief investment officer at Wave Capital Management. “If inflation is weak, there is potential for the Fed to expect.”
But the stock market may not even need a Fed put. This quarter's results are strong, with the economy expected to grow 4.2% in the second quarter, according to the Atlanta Fed's GDPNow tool. Together, these create a powerful combination, said Chris Seniek, chief investment strategist at Wolf Research.
“Chairman Powell's reinstatement of belief in the 'Fed Put' last week, combined with the very solid earnings trends emerging from the first quarter earnings season, leaves us feeling positive about the outlook going forward. 'can be done' [market] outlook,” he writes.
This represents the market environment in 2019.
S&P500
Advertisement – SCROLL TO CONTINUE
2018 came into the year despite a decline following a year-end decline due to the Fed's interest rate hikes. The Fed then kept interest rates on hold in January 2019, saying it would carefully consider inflation and other economic indicators in determining interest rates. The market took this as a signal that the Fed would eventually cut interest rates, and the S&P 500 index rose 29%.
This year probably won't be exactly like 2019, but with the Fed back, it should still be a pretty good year.
Email Jacob Sonenshine at jacob.sonenshine@barrons.com.
