The stock market is freaking out over the end of free money. It all has to do with something called ‘the Fed put’

You may have noticed some turmoil in the stock market recently.

It took a while to sink in after last week, but investors completely freaked out Friday through Monday when they realized just how serious the Fed is about fighting inflation.

As a result, stocks posted their worst start to the year since 1939, with the S&P 500 falling more than 16%.

What changed?

In short, last week was the end of the “free money” era of central banking. Since the start of the pandemic, the Fed had supported markets with extremely accommodative monetary policy in the form of near-zero interest rates and quantitative easing (QE). Stocks prospered under these loose monetary policies. As the central bank pumped liquidity into the economy as an emergency lending measure, the safety net for investors chasing all kinds of risky assets was established.

But starting in March, when the Fed raised its benchmark interest rate for the first time since 2018 to tackle inflation, everything changed. The move, which was followed by another half-point rate hike on Wednesday, marked the end of the free money era.

Markets are now experiencing what Wall Street watchers call “regime change,” and understanding how far equities could fall as a result requires understanding how markets value a lack of Fed support going forward.

Regimes that are changing

Since the Great Financial Crisis of 2008, the Federal Reserve has kept the cost of borrowing low, allowing consumers to invest in homes, cars and their education without the burden of high interest payments. This made sense when inflation and wage growth were low, as consumer spending needed a boost wherever possible.

Now, however, with unemployment rates near pre-pandemic lows and inflation rising even beyond historically high wages, the central bank has changed tack, raising interest rates and signaling its intention to cut your balance sheet to the tune of billions of dollars each month.

The regime change has left the markets on their own and caused risk assets including stocks and cryptocurrencies to crash as investors grapple with the new norm. It has also left many wondering if the era of the so-called Fed put is over.

For decades, the way the Fed enacted policy was like a put contract, stepping in to avert disaster when markets experienced severe turmoil by cutting interest rates and “printing money” through QE.

Fed officials argue that significant market declines could trigger a cascade of debt, destabilizing banks and the financial system as a whole, so they must act when times are tough to restore market order.

This policy led investors to understand that the Fed would come to the rescue if stocks fell. But under a new, more aggressive regime, many wonder if that is still the case.

If stocks continue to fall, will the Fed cut rates and reinstate QE to stimulate growth? Or will the markets be left to fend for themselves?

The Fed put

The idea that the Fed will come to the aid of equities in a recession began under Fed Chairman Alan Greenspan. What is now the “Fed put” was once the “Greenspan put,” a term coined after the stock market crash of 1987, when Greenspan lowered interest rates to help companies recover, setting a precedent that the Fed would intervene in uncertain times.

It was a monumental shift in policy from the era of Paul Volcker, who served as Fed chairman from 1979 to 1987. Volcker is widely credited with curbing the inflation of the 1970s and 1980s through the use of aggressive monetary policies. .

However, his policies were also in part the cause of the 1980-1982 recession and caused large deficits in the federal budget as the cost of borrowing soared amid the Reagan administration’s tax cuts and spending. military record.

Greenspan, on the other hand, ushered in an era of more dovish monetary policy, cutting interest rates on several occasions when stocks fell, even after the dot-com bubble burst in 2001.

And every Fed chair since Greenspan has followed suit, using interest rate cuts as a way to improve investor confidence and catalyze investment when stocks fall. Fed Chairman Ben Bernanke, who served from 2006 to 2014, went even further after the housing bubble burst in 2008, slashing interest rates and instituting the first round of QE ever seen in the US. .to help the country weather the economic storm.

Since then, when stocks experienced serious declines, investors have looked to the Fed for support, but that era may now be over as inflation pushes the central bank toward a new, more aggressive approach.

A new normal for stocks

If the Fed’s put option comes to an end, the current business cycle will likely be very different from previous ones, especially for stocks, says Jim Reid, head of thematic research and credit strategy at Deutsche Bank.

“Many topics will be different than what we are used to,” Reid wrote in a note Monday. “One of those themes is the relentless march of US stocks. The last decade was notable for record-long periods without a correction, a no-fight-the-Fed mentality, and a buy-the-fall narrative.”

Reid noted that last week marked the first time the S&P 500 fell for five consecutive weeks since June 2011, ending the longest streak without five consecutive weeks down since the relevant data began to be tracked in 1928.

“In the 83 years between 1928 and 2011, we had 61 series of five or more weekly drops in a row, one every year and a third on average,” Reid wrote. “So the last decade has been very much the exception rather than the norm.”

Martin Zweig, a renowned investor and analyst who was well known for calling out the 1987 market crash, coined the phrase “Don’t fight the Fed” decades ago. And for years, investors used the phrase as a mantra signifying the importance of staying invested while the Fed trailed the markets, acting as a safety net against recessions. Now, “Don’t fight the Federal Reserve” may have a new meaning.

As Zweig wrote in his book win on wall street:

“In fact, the monetary climate, mainly the trend in interest rates and Federal Reserve policy, is the dominant factor in determining the main direction of the stock market. In general, an uptrend in rates is bearish for stocks; a downward trend is bullish”.

As long as the Fed kept interest rates historically low and pumped billions of dollars into the economy each month through QE, it made sense to keep investing in risky assets. As Zweig describes, falling interest rates reduce stocks’ competition with other investments, including Treasury bills, money market funds, and certificates of deposit. “So as interest rates fall, investors tend to bid higher prices, in part out of the expectation of better earnings,” Zweig wrote.

Now, with the Fed raising rates and ending QE, it’s a whole new era, one that might not be so kind to risky assets.

But investors still can’t fight the Federal Reserve. It’s just that the central bank is no longer pushing them into high-flying tech stocks and cryptocurrencies. Instead, it is making other, perhaps less risky, assets look more favorable. Assets that typically perform in rising rate environments, such as short-term government bonds and value and dividend stocks, may outperform in this new era. Don’t fight it.

This story originally appeared on Fortune.com

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