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The Fed Put Is Necessary For Markets To Function

Posted by Ian C. Carroll on May 28, 2020 11:38:18 AM
Ian C. Carroll
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  • The Fed Put is the belief that the Fed will rescue the market
  • The Fed has two main tools in its toolbox: cut interest rates and buy securities
  • The Fed's recent moves were necessary to help stabilize markets and the economy

In the wake of the recent bond market meltdown there's been a lot of talk about something called the "Fed Put."

In the equity markets, a put option gives the owner the right, but not the obligation, to sell the underlying security at a predetermined price by a certain date. The seller of the option takes on the obligation to buy the underlying security at the predetermined price if the buyer wants to sell. The buyer of the put is hedging against the market falling. The seller has to buy the securities if the buyer is right.

The Fed Put says that the Federal Reserve (Fed) will step in when the market falls sharply, taking actions that effectively create an artificial bottom -- analogous to selling a put. This is supposed to stabilize the market, calm investors and lenders, and help the economy recover. This is not a literal put or a technical put, but an implied put. The implication being that if the market falls into crisis and liquidity dries up, the Fed will come to its rescue, typically by lowering the federal funds rate.

The Fed funds rate is the benchmark for short-term interest rates. Lower borrowing costs keep corporations confident they can access credit markets, and continue operating and employing their workforces. It also helps ease investor fears of layoffs and recession. A big part of the Fed’s balancing act is to keep rates just low enough to keep the economy growing, but not so low that it causes runaway inflation.

Greenspan Put

Originally called the Greenspan Put, because Fed Chair Alan Greenspan used it during the 1990s, it appears to have become official policy and another tool in the Fed's toolbox. There are two primary tools in this toolbox to help the economy and markets. The main one is to lower interest rates. The second, instituted by Fed Chair Ben Bernanke in the 2008 fiscal crisis, is quantitative easing (QE). In QE, the Fed literally enters the bond market and buys securities.

The "Fed Put" In Action

In late February, as the coronavirus outbreak harmed communities and economic activity, both the stock and bond markets fell sharply. The Fed decided to drop the Fed funds rate 50 basis points on March 3. Over the next two weeks markets continued to fall. On March 15, the Fed took dramatic action and lowered rates an additional 100 basis points on a Sunday when the market was closed. That effectively cut the interest rate to 0%, essentially free money.

With nowhere left to go, but into negative rates, which they say they don’t want to do, the central bank also launched an unprecedented QE program. The Fed plans for $750 billion to buy new and existing corporate bonds, including some high-yield bonds and fixed-income ETFs.

It was a stunning move and extraordinarily nimble in addressing the situation.  The Fed and current Chair Jerome Powell deserve two gold stars for this move.

The Focus is Full Employment

While many claim the Fed Put creates a moral hazard and encourages excessive speculation, I say the Fed Put is good, even necessary. What would you have the Fed do instead? Let companies fail? This would punish workers by eliminating their jobs. It could take years for these people to find new work. All the while the economy would suffer.

One of the Fed's mandates is explicitly focused on full employment. So, any move to prevent massive unemployment falls under its purview.

Having the Fed ready to step in and buy securities when liquidity dries up and markets fall apart is necessary for keeping financial conditions acceptably loose, so companies can continue accessing credit markets, which have become the life blood of corporate America.

Necessary to Keep Markets Functioning

A large part of the corporate credit market consists of issuing new debt in order to retire old debt. A well-oiled credit market is critical to corporate America functioning efficiently, which is necessary for keeping people employed and the consumer strong. Isn't that what everyone wants?

In this instance, the Fed has been very clear on its intention to buy credit, keep rates low and basically do whatever it takes to support the market. This creates a situation where consumers and companies can continue to borrow, refinance debt and shore up cash positions.  Without that backstop, who knows where we would be right now? The crisis could have triggered a depression-like reaction in the financial markets.

We See Opportunity

The recent use of the Fed Put was very important, helping spreads narrow by almost 50%. This partial retracement makes sense because Covid is still hanging over the economy and many corporations are not getting the necessary cash flow. But having the Fed there takes away a lot of the tail risk that results from markets gripped by fear.

When markets are gripped by fear, liquidity evaporates and even high-quality credit plummets. Aware Asset Management saw opportunity in March and April. We recognized it was market illiquidity, not actual credit default risk that drove prices down.

We remain selective buyers and that decision is made easier with the Fed programs in place. We think there are still good values in credit, especially in BBB-rated companies that have higher leverage, but baseline cash flows that can accommodate operating needs and survive the shutdown. We want debt profiles that show strong balance sheets, with enough cash and credit facilities to manage operating interruptions and inevitable supply-chain reconfigurations.

Ian C. Carroll, CFA, CIPM

Head of Corporate Credit Research

Aware Asset Management

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