In April of this year, Deutsche Bank calculated the level of the new “Powell Put,” noting that one can estimate the strike of that ‘put’ in two different ways.
First, delta neutral, in which a rise in vol is compensated with lowering of the strike in such a way that the underlying is unchanged. Using this approach we find that the S&P drop started at the point when S&P was at 2800 which places the new strike of the Fed put somewhere in the 2300 — 2400 range.
Adding that the “Fed put is embedded in the beta, which represents response of stocks to rates rise. Higher strike, i.e. lower deductible, implies a more protective Fed; lower beta corresponds to a higher deductible or a lower strike of the put.” And as shown above, where previously the beta was 10, it has since jumped to 30, meaning that the Fed remains highly protective (as Bank of America repeatedly showed before). According to Kocic, “this is a residual of the Fed’s awareness of the distortions caused by QE as well as the market’s vulnerability to stimulus withdrawal.”
And as Deutsche further explaineds, it is very unlikely that the market will sell off in a calm, cool and collected manner from its current level to 2,300; in fact, the drop would likely be far more stormy as a result of unwinding convexity flows, which push investors out of equities and into bonds. His explanation below:
Restriking of the Fed put is a withdrawal of convexity from equities. It is effectively a removal of a put spread from the market. However, in the environment where everything is bound to sell off (a market mode that is a mirror image of QE), volatility is one of the key decision variables. More volatile equities are less desirable than less volatile duration. In that environment, convexity withdrawal creates a reinforcing loop where more turbulence in risk assets tends to cause stability in fixed income. The figure shows the convexity flows across the two markets.
The implication of these cascading convexity flows is that as equities tumble, there would be an outsized bid for all fixed income instruments:
Restriking of the Fed put is re-syphoning of convexity. Withdrawal of convexity from equities means higher volatility and their underperformance, which fosters preference for bonds and reinforces their stability. This becomes a supply of convexity to rates and, as monetary policy remains in place, this means: higher real rates, stronger USD, and lower expected inflation (which reduces the tail risk of the bond unwind). All of these make bonds more desirable than risk assets.
And following yesterday’s collapse (and today’s follow-through), Krishna Guha, the head of central bank strategy at Evercore ISI, warns that it will take a correction of at least 10 percent to get the Fed’s attention and even that probably won’t be enough to derail expected interest-rate increases..
“It would likely take a much larger 15 percent to 20 percent correction to force a more far-reaching revision to the Fed’s policy plans,” he wrote in a report, adding that… “policy makers are also likely to consider volatility in the exchange rate and credit spreads. The idea that policy makers would ease monetary conditions in times of sharp declines is known as the ‘Fed put’.”
As Bloomberg notes, a 10% drop from the S&P’s record close of 2,930.75 would put it around 2,638 — well below yesterday’s 2,785.68. A 20% plunge would take it all the way down to 2,345, a level not seen since the middle of 2017, but getting closer to where the global central bank liquidity spigot suggests… and agreeing with level suggested by Deutsche Bank…
However, as Bloomberg reports, Westpac Banking Corp. Senior Strategist Sean Callow warns that the confidence the Fed has expressed in the U.S. economy’s resilience means it will probably see the equity pullback as “immaterial to the growth and inflation outlook.” In short that means – as we previously noted – The Fed is in a corner where it has to keep hiking to sustain confidence in the economy:
“RIP the Fed put,” Callow added. It’s “dead — at least for some time, if not forever.”
Finally, Ian Lyngen of BMO Capital Markets said a common view among clients he’s talked to is that the last several weeks have seen events that “should have” challenged Fed Chairman Jay Powell’s “everything-is-awesome narrative.”
“While the President might believe normalization to be ‘loco,’ that clearly isn’t a view shared by the FOMC,” Lyngen wrote.
Evercore’s Guha concludes by noting that changes in credit spreads as possibly being more important than repricing of equity markets, and while credit has started to snap, it’s not enough yet…
“But absent much sharper market moves/escalation of economic risks, given the context of strong economic momentum and two-sided risk, we think the central bank is likely to stick to gradual quarterly hikes for now.”
We tend to agree and are reminded that it was Powell himself who in October 2012 told his fellow FOMC members the following truth:
I think we are actually at a point of encouraging risk-taking, and that should give us pause. Investors really do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but that they have every incentive to take more risk, and they are doing so. Meanwhile, we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy.
It was your strategy until 2018. The question now is what your strategy will be going forward.
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