Fed Put Talk Resurfaces

I was minding my business this morning, studying my usual arrays of financial news and charts in search of a topic for today, when my ears perked up. A commentator on TV used the phrase “Fed Put.”  If that is a topic of conversation and a rationale for another round of stock buying, it seems to be my duty to remind people about what this mythical option is all about.

For starters, the “Fed Put” is a concept, not an actual option.  Put options have a defined strike and an expiration date.  The “Fed Put” is perpetual and has no fixed strike.  It instead refers to the tendency for the Federal Reserve to add liquidity to the system and/or cut rates in times of major financial stress.

The Fed Put is meant to be “break glass in case of emergency,” not “let’s keep the stock market propped up.”  It’s systemic disaster insurance, not minor correction insurance.  If there is an issue that threatens the stability of the banking system or credit markets, then the Fed reacts. Think of the Fed Put more like fire insurance as than a collision policy.  It’s meant to contain conflagrations, not for fender benders.  

If the Fed Put did have a strike, equity investors would grossly overestimate its strike price.  Folks often seem to think it’s struck 2-5% below whatever the current price of the S&P 500 Index (SPX) might be.  If that were the case, we would have seen it activated in 2022.  Think about it.  If the Fed was really in the business of protecting equity investors, wouldn’t they have done so last year?  I’ve asserted before, and will do so once more, that the “Fed Put’s” strike is not only variable and unknown, but it is tied to rates and/or credit spreads anyway. 

It is understandable why equity investors might perceive the “Fed Put” as their own.  It came about as the result of the Crash of 1987.  On its 35^th anniversary I gave my first-hand account of witnessing its birth.  The “Fed Put” was indeed prompted by plunging equity prices, but what spurred the Fed into action was that crashing stock prices were causing problems at the banks that financed the clearinghouses and various trading firms.   

To be sure, stocks benefit from Fed largesse, but that was the only time they were the primary target.  Since then, the “Fed Put” has only been triggered when other types of systemic risk arose, none of which stemmed directly from the stock market.  If we’re talking about the need for the Fed Put, things would need to be markedly worse than they are now – think banking crisis, repo failure, recession.  There are valid reasons to be bullish about stocks, but imminent implementation of the Fed Put shouldn’t be one of them.  Nothing good would cause that to occur.

I recently co-hosted an IBKR podcast with Tony Crescenzi from Pimco.  My main takeaway came from a discussion about how short-term rates affect riskier assets.  He shared Pimco’s model, which has concentric circles of risk – repos and Fed Funds in the middle, equities in the outer ring.  It occurred to me that too many equity investors see themselves at the center of that solar system, not an outer planet.

Quite frankly, that view is long-outdated when it comes to both astronomy and the Fed Put.  As with far too many things that underlie the bullish sentiment for equities – at least the ones that are based upon a return to rate cuts — it’s very much a “careful what you wish for” thing.