In Search of the Fed Put

Investors are waiting to hear from Powell on whether the Fed still has their back at the SPX 200d MA. We suspect they don't. The Put is Lower.

The risk off environment we have been calling for and witnessing over the last few weeks has largely been driven by the market waking up to the realization that the Fed (with support from the Biden administration) has become more serious about ensuring that inflation does not become entrenched into the societal psyche. We have had countless Fed members continue to out-hawk one another over the last few weeks in order to demonstrate to the market that they mean it this time. QE is ending, rate hikes are coming, balance sheet reduction is likely, financial conditions will be tightened. And even this past weekend, the WSJ (the Fed’s preferred communication strategy vehicle) along with Goldman Sachs both reminded investors that the Fed has the ability to hike at any meeting, not just on the quarterly meetings when a new SEP is given. That opens up the possibility of faster hikes and possibly more than 4 hikes this year. A Fed that is focused on tightening financial conditions rapidly is a headwind for risk assets. Full stop.

However, markets have been on the ropes in January, technical levels have been breaking, volatility has been rising, credit spreads have begun to widen and investor performance to start the year has largely been poor. So, that begs the question: How much weakness will the Fed allow? What conditions are necessary for them to change course and flip back to dovish? WHERE IS THE FED PUT?????!!!!!

We continue to hear this question asked by investors, on Twitter, on CNBC, on Bloomberg, everywhere where anyone wants to discuss the current market environment. It is all anyone cares about. It’s basically the short term driver of all risk assets when correlations rise like they have been. And the reason for this is that investors have become so accustomed to a Fed put that has been basically struck at current market levels and certainly at no worse than the 200d moving average for quite some time. It has been this mentality which has allowed for the BTFD mantra that has been present in markets for at least a decade and likely since Greenspan kicked this off in the late 90s with his response to the Asia FX and LTCM crises. The Fed’s liquidity is the engine that keeps the risk markets running.

So where are we now? At the risk of saying “This Time is Different,” the truth is that conditions today are strikingly different from prior episodes of Fed “pivots” from hawkish to dovish. The Fed is hitting on both of its stated mandates. Currently, inflation is running above 7% and is expected to continue to run hotter than expected throughout 2022 and into 2023. The labor market is tight, the unemployment is less than 4%, and we are closer to maximum employment than we have been in quite some time. It is thus hard to justify the current easiness of financial conditions and with the data expected to remain firm on both of these measures for months to come, it will be hard for the Fed to reverse course quickly based on the data. On the Fed’s unspoken third mandate, which they have described as “smooth Treasury market functioning,” there are no signs of strain here and the Fed has put in various facilities over the course of the last 2+ years since the late 2019 Repo crisis to help provide investors with comfort in the idea that the Fed will be there if needed. But right now, they are not needed, the Treasury market is smoothly functioning.

As a result, the market is now on an exploration mission, trying to find where the Fed put exists since it is no longer struck at the 200d MA. The issue for the market is that as long as CPI remains elevated, Unemployment rates are low and the Treasury market remains "smooth functioning," there is really nothing the Fed can provide the equity market at this point to give comfort that it is now time to reverse course on policy. There will be a point in the future, when the market correction leads to tight enough financial conditions (higher interest rates, credit spread widening, volatility elevated etc.) that start to threaten employment gains and the recovery of the economy. It is as that point that the Fed would look to pivot back toward being easy again. The issue for investors now is that we are not there yet and there is a time gap before we can really get there. And an unsettled market searching for clarity is not a healthy market. So we will need more market pain first in order to find the risk asset price levels that start to threaten the recovery. I suspect the Fed will deliver that painful message to investors on Wednesday. Today’s bounce is to be sold.

*Important Disclaimer: This blog is for educational purposes only. I am not a financial advisor and nothing I post is investment advice. The securities I discuss are considered highly risky so do you own due diligence.