Can investors survive treacherous markets without the ‘Fed put’

And the Fed is also shrinking its bloated $US8 trillion balance sheet at a clip of $US95 billion a month, even though this is exacerbating the indigestion in the US bond market.
Despite the Fed throwing its two monetary levers sharply into reverse, the US economy remains remarkably robust.
Former US Treasury Secretary Larry Summers argues that this resilience suggests traditional monetary policy could be losing traction.
“We’ve got something of an ‘Energizer bunny’ economy”, Summers said in an interview on Bloomberg Television, after the release of figures showing surprisingly strong US jobs growth last month.
“We may be living in a world where the interest rate is less of a tool for guiding the economy than it used to be”, he said. “That means when things need to be cooled off, interest rates are going to have to be more volatile than they have been in the past.”
Summers pointed to a number of factors that could be reducing the US economy’s sensitivity to interest rates.
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US homeowners had taken advantage of ultra-low interest rates to lock in low mortgage rates, and this was making them reluctant to sell. The reduced inventory of homes was driving up property values, making people feel wealthier and helping to sustain spending.
At the same time, he said, higher interest rates also means “more money in people’s pockets”.
In addition, he pointed out that some business investment, such as artificial intelligence, takes less time to implement, which reduces sensitivity to the level of interest rates.
Summers warned the combination of soaring bond yields and elevated asset values, along with China risks, meant there was “more dry tinder for financial flames than I’ve seen in quite a long time”.
And that raises the most worrying question of all for investors: has Fed chairman Jerome Powell quietly allowed the so-called “Fed put” to expire?
The idea that the Fed would do what was necessary to calm turbulent markets emerged just over 25 years ago, following the collapse of US hedge fund Long-Term Capital Management.
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The hedge fund, which boasted Nobel Prize winners Robert Merton and Myron Scholes among its top ranks, claimed to have discovered a way to generate huge returns with minimum risk by taking massive, highly leveraged bets on assets it believed were mispriced by markets.
But LTCM’s strategy imploded when the Russian debt default in August 1998 resulted in investors flocking to safe assets, particularly US government bonds. As financial markets froze up, LTCM could not unwind its big bets.
The situation was so worrying that the Fed, then chaired by Alan Greenspan, was forced to intervene, orchestrating a $US3.6 billion bailout funded by a consortium of 14 Wall Street banks.
And even though US economic activity at the time was strong, the Greenspan-led Fed took the added precaution of cutting interest rates to buoy investor confidence.
The Fed’s actions encouraged investors to expect the US central bank would ride to the sharemarket’s rescue whenever it suffered steep losses.
In essence, the Fed was essentially providing investors with a free “put option” – a financial instrument that traders use to limit their losses.
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Investors’ belief in the existence of the “Fed put” was reinforced when the US central bank predictably cut interest rates after the collapse of the dot-com bubble, and again in 2007 as the US housing bubble was bursting.
By late 2008, with its benchmark interest rate close to zero, the Fed started buying US government bonds and mortgage-backed securities in an attempt to push long-term bond yields lower.
Again, when the coronavirus pandemic struck in early 2020, the Fed cut interest rates close to zero and resumed its aggressive bond-buying program.
The Fed’s willingness to use its monetary tools to support equity markets largely reflected a concern that falling share prices would damage the economy, through the negative wealth effect.
But now that the Fed finds itself dealing with an “Energizer bunny”, this fear has dissipated. And with it has disappeared the need for the “Fed put”.
And that means investors can not count on the Fed riding to the rescue of tumbling bond or equity markets going forward.

This data comes from MediaIntel.Asia's Media Intelligence and Media Monitoring Platform.