When I was in high school I knew that hubris would usually suffice when I had trouble coming up with a topic for an English paper. An inflated sense of self-importance was a repeated fatal flaw, from Greek tragedies, through Shakespeare, and into modern literature. Yet here I am this morning, writing about it once again – this time regarding equity investors and the “Fed Put”.
In May, in an article entitled “The “Fed Put” Lives. But It’s Never Been About Stocks” we outlined our thesis that equity investors should not delude themselves into thinking that a decline in the stock market would provide sufficient impetus for the Fed to intervene “until or unless we see our stock market malaise metastasize into the credit markets or the economy as a whole” We outlined previous examples when the Fed either intervened (such as 1987 or 2008) or chose not to (such as 2001), with the common theme being that the central bank only acted when the credit markets or the economy as a whole was threatened.
This week we saw the “BOE Put” activated when the Bank of England stepped in to buy UK Gilts. Rapid declines in the gilt market were metastasizing into a major credit crisis. The culprit was a style of investing called “LDI”, or “Liability-Driven Investing”. In short, defined benefit pension funds were using LDI to assist them in meeting their obligations amidst a low-interest rate environment. As rates rose, they now needed to post more collateral against the embedded derivatives in the LDI strategies. This created a nasty feedback loop that risked destabilizing UK credit markets. (This article from the Washington Post has an excellent explanation)
Put simply, the BOE stood by for months and even continued to raise rates as gilts, stocks and the pound all fell steadily. They only stepped in when the credit markets were severely threatened. And their actions stopped the bleeding. The pound now stands at about 1.115 versus the US dollar, up from about 1.055 when the BOE began buying gilts. Yields on 10-year gilts are now about a full percentage point lower. The FTSE 100, however, closed today less than 1% above its Wednesday pre-intervention lows. Whoopee! It’s another reminder that when central banks make their moves, it’s not usually about equities.
I used to compare my long-time role as an options market maker to that of an umbrella salesman. When the sun is shining, few think about raingear. Their concern only grows when storm clouds gather, and it’s usually too late to act once the rain starts. During times when the Fed is adding liquidity to the system, volatility and skew tend to be dampened. An unending flow of liquidity can justify relative complacency. When central banks are draining liquidity, we tend to see volatility rise as investors seek protection. This is something we warned of prior to the start of this year, writing: “The primary theme [for 2022] is for investors to expect more volatility than we’ve seen over the past year-and-a-half. The changing monetary environment should be the cause.”
Equity investors who choose to forego protection or risk management in the hope that the Fed or one of its counterparts will come riding to the rescue are playing a dangerous game. If you believe that the stock market is of primary concern to central bankers, please disavow yourself of that notion. At some point the Fed will undoubtedly veer away from its restrictive course. But the likeliest reasons for a course change, or pivot, would be either that we have veered into recession or dire credit market conditions have forced their hands. If that’s your hope, careful what you wish for.
Disclosure: Interactive Brokers
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