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The Fed Put is Back – But What Exactly IS a Fed Put?

Some of us are old enough to remember last October, when Federal Reserve Chairman Jerome Powell steadfastly commanded that “The really extremely accommodative  low interest rates that we needed when the economy was quite weak, we don’t need those anymore…  Interest rates are still accommodative, but we are gradually moving to a place where they will be neutral, we may go past, but we are a long way from neutral at this point.”

After markets threw a hissy fit in October and a full on twitter onslaught from President Trump, Chairman Powell stood his ground at the December Federal Open Markets Committee (FOMC) meeting with an (expected rate hike) and though he signaled further hikes could slow he was firm on the idea that the Fed would not be altering its plan to reduces the size of the balance sheet (in effect reversing the actions of 3 previous rounds of quantitative easing).

The Markets responded with another hissy fit and finished December down nearly 9%, but monetary hawks had hope that perhaps Chairman Powell would be the first Chairman since Paul Volker to step up and deliver the medicine that some feel is needed to prevent another cycle of bubble inflation and subsequent collapse.

 

 

“Nice Fed You Got There, Be A Shame if Something Happened to It”

Then a funny thing happened.  In early January at an economic forum in Atlanta Mr. Powell while flanked by former Chairman Bernanke and Janet Yellen, “We’re listening carefully with – sensitivity to the message that the markets are sending and we’ll be taking those downside risks into account as we make policy going forward,”   With that most observers agreed that the Fed Put was in place and the markets staged a 747 point rally on the Dow Jones Index for the day.

Fast forward to yesterdays FOMC meeting where  Powell  declared that the case for further rate increases has weakened somewhat.  Furthermore the statement released stated that the FOMC “would be prepared to use its full range of tools, including altering the size and composition of its balance sheet if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal-funds rate.”

There can be no doubt at this point the Fed (Powell) Put is on.  It is almost as if someone visited the Federal Reserve, took a look around and said “Nice Fed you got here, be a shame if something happened to it.”

 

What exactly is the Fed Put?

The Fed Put is the evolution of policy originally implemented by former Chairman Alan Greenspan, which allowed traders and speculators to take on risk knowing that the Federal Reserve would come to the rescue of financial markets with gifts of emergency liquidity and eventually asset purchases.  It originated in the aftermath of the 1987 stock market crash, was re-applied to address the Long-Term Capital Management crisis,  dusted off for the Dot-com bubble, and even mentioned preemptively for the 2008 housing crisis when referring back to when  Chairman Ben Bernanke delivered his 2002 (prior to becoming Fed Chairman)  infamous helicopter money speech.

A put is a an options contract that allows its owner to sell an underlying security (or index value)  to a counter-party for a pre-determined price within a specified time frame.   It is commonly used as a form of insurance for someone owning stocks that ensures in the event of a market downturn they will  be able to sell their stock to someone at a set price.  In other words the owner can “put” the stock to someone else.

Lets say that on the way home from a cocktail party Johnny  Investor gets a tip from his Uber driver that SureThing.com stock is….a sure thing, it can’t miss.  Well Johnny is a little skeptical, but he doesn’t want the train to leave the station without him so he steps up and buys a 1,000 shares of SureThing.com which is currently trading at 100.   Billy now has a $100,000 “investment.”  Johnny however becomes worried about the market, but he believes in SureThing.com and does not want to sell out and miss the party.

Johnny fires up his online trading account and buys a put.  For $2 (for each share of stock) he buys a contract that will let him sell said share to Billy Speculator for $90.

Well it turns out Johnny’s fears are spot on, and in the midst of a market sell off he wakes up one morning and sees that SureThing.com is now trading at $75 a share.  Instead of being down $25,000, his loss is offset by the gain of Johnny’s put options which are now worth $15,000 (90-15).  Remember he paid $2,000 for the options to start so in total he is only down $12,000 on his investment.  This is a number that he can stomach and allows him to hold on until the market rebounds.   Sure enough SureThing.com comes through and eventually goes on to $200 a share.

Johnny was able to profit from this stock because the put allowed him to take on a position he otherwise would not have been comfortable holding, knowing he could sell it back to someone for a minimum of $90.

Starting with the stock market crash of 1987 and continuing on with the Long-Term Capital Management crisis and the collapse of the dot.com Former Fed Chairman Alan Greenspan responded to these events with an assurance that the Fed would be ready to standby and provide whatever liquidity was needed to keep financial markets from collapsing into a 1930s style catastrophe where the stock market lost more than 90% of its value and did not return to peak levels for nearly thirty years.

Traders and speculators began to rely on these assurances and even referred to them as the “Greenspan Put.”  The Greenspan Put did not provide anyone with the specific ability to put their holdings to another party (that would not come until the collapse of Lehman Brother’s and the expanding of the Fed Balance sheet), but they did rely on the comfort that any down turn in the markets would be met with swift accommodative action by the Fed that would lessen losses and/or shorten the time frame of such downturns.

 

Raising the Stakes

While the Fed Put sounds nice in theory, the long-term ramifications are the creation of even larger credit financial bubbles that can be more dangerous than the one that investors are being saved from.  It kicks the can of consequences for economic mistakes down the road AND shifts the costs of these mistakes to the general public as opposed to those who took the risk in the first place.  It allows the moral hazard of keeping all the profits and socializing the losses.

Yesterday’s FOMC meeting and statement, can leave no doubt.  The Fed Put is on.

While it is good for the stock market and asset prices in the short term, it raises the prospect of increased volatility down the road.  As always investors need to walk the tight rope of staying invested to preserve future purchasing power with the risk of being overexposed to markets that are more likely to experience significant volatility.  Unfortunately the Fed put raises the stakes and lifts that tight rope higher, so any mistake (to either side) of that wire is a more dangerous fall.

 

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DISCLAIMER: Nothing in this article should be construed as a personal recommendation or advice. Nor should anything in this article be construed as an offer, or a solicitation of an offer, to sell or buy any investment security. Barnhart Investment Advisory clients and principals may hold positions in any securities mentioned in this article. Investors should conduct their own due diligence and seek the advice of a financial and/or investment professional before making any investment decisions.

Discussion

One thought on “The Fed Put is Back – But What Exactly IS a Fed Put?

  1. Thanks for informative post. I agree, the Fed put is definitely back. https://furiousfinance.wordpress.com/2019/01/30/the-powell-put-is-now-obvious/

    Posted by FuriousFinance | January 31, 2019, 2:32 PM

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