How long can the Fed ‘put’ hold sway?
IN HIS excellent article “How ‘the mother of all bubbles’ will pop” (BT, Dec 18) Ruchir Sharma correctly points out that Wall Street has been in the grip of an unprecedented mania for some time now, and argues that because virtually every analyst is predicting continued outperformance in 2025, this only confirms that the bubble is at a very advanced stage.
“If the consensus on ‘American exceptionalism’ is so overwhelming, who is left to hop on the bandwagon and inflate it further?” was the question posed.
The answer, in my view, is it would be those who continue to place their faith in the fabled “Fed put” which has backstopped the US market for more than 30 years now.
I have written about the Fed’s “guarantee” for markets, most recently in July, when the Dow Jones Industrial Average was just below 40,000 (it has since climbed to 45,000).
To recap, the term “put” is used because put options, being instruments that gain value in a falling market, are typically bought as insurance against market blowouts.
According to the Corporate Finance Institute, the Fed put is “the belief that many market practitioners hold that the Fed will step in with accommodative monetary policy to buoy markets, specifically the US equity market, if prices fall too fast too quickly”.
The Fed put first appeared in 1987 after the infamous Black Monday crash on Oct 19, when interest rates were brought down to near-zero by then Fed chief Alan Greenspan, to prevent a complete rout.
In 1998, Greenspan cut rates three times between September and December in response to global contagion fears stemming from the Asian financial crisis “to cushion the effects of increasing weakness in foreign economies and of less accommodative financial conditions domestically”.
It worked – the Dow gained 27 per cent to a then all-time high two months later.
After the 2001 terror attacks, Greenspan cut rates 11 times that year to a 40-year low of 1.75 per cent, from 6.5 per cent at the start of the year. This helped interest-rate sensitive sectors like housing and automobiles to recover, but it also spurred several massive waves of mortgage refinancing, thus sowing the seeds for a vastly greater catastrophe a few years later – 2008’s US subprime crisis.
Once again, the Fed put came to the rescue – rates were slashed to zero by then chair Ben Bernanke and several emergency liquidity facilities were launched under quantitative easing (QE).
In June 2010, the Fed attempted to scale back monetary policy by bringing QE to a close. When markets reacted badly to the news, the Fed quickly introduced a new QE programme called QE2.
Stocks took off – until the next crisis, which was the unforeseen Covid-19 pandemic in 2020.
Enter the Fed put again, when on Mar 3, 2020, Fed chair Jerome Powell cut rates by 50 basis points (bps) to 1 per cent, followed by a 100 bps reduction to zero per cent 12 days later, and implemented a US$9 trillion Fed balance sheet expansion. Once again, Wall Street rallied like there was no tomorrow.
At time of writing, the Dow has fallen for 10 consecutive days and the Fed has signalled fewer cuts next year because inflation is still a worry. Could this be the start of the bubble bursting?
It could be, but I doubt it, because the Fed put is simply too deeply embedded in the market’s psyche. It will be interesting to see if I am wrong.
