Farewell, the ‘Fed Put’

I f ever a Federal Reserve has been the stock market’s friend, it has to have been Jerome Powell’s Fed. However, if the recently released minutes of the Fed’s last policy meeting come to pass, the central bank will soon become anything but.

Not only will markets have to learn to cope, at least for a prolonged period, without the benefit of the so-called Fed put, whereby the central bank can be counted upon to support the market at a time of weakness. They will also have to deal with a Fed that’s intent on draining large amounts of liquidity as part of its effort to regain control over inflation.

By any measure, the Powell Fed’s response to the Covid-induced economic recession in March 2020 has been truly dramatic.

Much like the Bernanke Fed’s response to the financial crisis of 2008 and to the recession that followed, the Powell Fed kept policy interest rates at their lower-zero bound. Yet while it took the Bernanke Fed six years to increase the size of the Fed’s balance sheet by $4 trillion through massive bond purchases, it took the Powell Fed less than one year to do the same.

Even last year, at a time when the economy was recovering strongly and both the stock and housing markets were on fire, the Powell Fed continued to flood the market with liquidity. It did so by continuing to buy $120 billion a month in U.S. Treasury bonds and mortgage-backed securities.

In response to the Fed’s zero-interest-rate policy and its liquidity flooding, the stock market staged its strongest rally on record. Indeed, from its low in March 2020 to its peak at the end of 2021, the S&P 500 approximately doubled. By year’s end, U.S. equity valuations — as measured by the Shiller cyclically adjusted price-to-earnings ratio — were approximately double their long-run median average and at levels experienced only once before in the last 100 years.

The big fly in the ointment, however, has been that while the Powell Fed’s monetary-policy largesse produced the strongest stock-market rally on record, it also contributed to the fastest inflation since 1981. It now appears to be abruptly changing gears to correct for this reality.

Indeed, the minutes of its most recent monetary-policy meeting strongly suggest that, beginning at its scheduled May 3–4 meeting, the Fed will adopt a considerably more-hawkish monetary-policy stance. Not only is it now envisaging raising interest rates in 50 basis-points steps rather than 25 basis-point steps; it is also planning on reducing the size of its balance sheet by $95 billion a month.

The possible implications of this course of action for a highly valued stock market cannot be overemphasized. Instead of adding $120 billion a month to market liquidity as it did through much of 2021, the Fed will now be draining $95 billion in liquidity by not rolling over its bond holding at maturity.

If high inflation forces the Fed to stick to its plan, the market will also not be able to rely on the Fed put in time of weakness: a necessary expectation to provide a market floor and to avoid any abrupt downward movement in stock prices.

The bond market has seemingly internalized the importance of the Fed’s proposed shift in policy stance as underlined by the fastest rise in ten-year Treasury bond yields since 1994 and by the inversion of the yield curve. Surprisingly, the equity market has not yet internalized the idea that just as the Fed’s $120 billion a month liquidity injection buoyed markets in 2021, a proposed $95 billion a month liquidity withdrawal could end the stock market’s party — not least by precipitating an economic recession.

Only time will tell whether it is the bond market that is being too gloomy or the stock market that is being too much of a Pollyanna. Given the bond market’s strong track record of predicting economic recessions, however, the odds favor its being right this time around as well.