Has the “Fed put” vanished?

So far, 2022 has been painful for capital markets, with equities experiencing their third-worst start to a year on record and the bond market experiencing its worst drawdown since the 1930s. Last week was particularly volatile as sentiment among stock investors whipsawed and the 10-year Treasury yield broke above 3%, its highest level in 3½ years.

The equity and bond markets have become increasingly intertwined as the Federal Reserve has greatly enhanced their transparency. Investors have recently referenced a “Fed put,” a term that originated under former Fed Chair Alan Greenspan, believing that the Fed will provide insurance against protracted equity market declines through aggressive policy. In the post-financial-crisis period, quantitative easing provided similar confidence to the bond market, with the Fed’s balance sheet rising from under $800 billion in 2008 to nearly $9 trillion today.

The Federal Open Market Committee (FOMC) voted to raise the Fed funds rate by 0.50% at its May 4^th meeting, along with announcing a detailed plan to reduce its balance sheet. The initial reaction to the Fed’s decision was bullish, as Chair Jerome Powell calmed fears that a 0.75% hike was looming. This was the first occasion when the S&P 500® Index rallied 2% on the day of a rate hike since March 21, 2000; that was just days before the technology bubble’s peak. The rally on May 4 was more than offset by a decline the following day, as investors came to terms with what may likely be a prolonged cycle of higher rates. For context, the bond market does not believe in the Federal Reserve’s rate path outlook and fears a credibility crisis. As the chart above illustrates, as the Federal Reserve removes liquidity by reducing its balance sheet (through quantitative tightening, which is the opposite of quantitative easing) to tackle the fastest pace of inflation the U.S. has witnessed in over 40 years, a roaring stock market isn’t conducive to the Fed’s new priority of taming inflation.

Likewise, Strategas argues that the “Fed put” is gone too. They think “the Fed took the liberty of forecasting inflation last year, and it whiffed. In our opinion, the Fed is unlikely to stop tightening until its preferred measure of inflation, the core personal consumption expenditure (PCE) index, is closer to 3.0% than its current 5.2%, almost regardless of movements in the financial markets.” These market sentiments do not bode well for already jittery investors. The recent months have been nothing short of doses of bad news for the markets, with a surge in inflation, tighter monetary policy, supply chain issues, and the Russian invasion of Ukraine. Indeed, many investors feel there’s no port of safety as almost every asset class has sold off so far this year.

The markets’ pain has not caused the Federal Reserve to shift course, however, as the fear of inflation so far has superseded capital market declines. Investors are uneasy about an environment when the Fed does not support capital market returns, and volatility will likely remain elevated until the focus returns to the fundamentals.