Stocks have been rocky since the start of the fourth quarter, and while investors are worried about a few things from tech stocks to crude oil to junk bonds, but I think the primary concerns are interest rates and the Federal Reserve.
There are three huge questions on the table. First, how high will the Fed raise short term interest rates? Second, what is the Fed going to do with their balance sheet? Third, and perhaps most critically, will Fed Chair Powell deliver the ‘put’ option that Greenspan, Bernanke and Yellen all did during their respective tenures.
Right now, markets still believe the Fed will raise interest rates at their next two-day meeting on December 18th and 19th. Beyond that, there’s a lot of disagreement.
The Fed has signaled that they will raise the overnight rate to 2.5 percent in December, 3.0 percent in 2019, and 3.5 percent in 2020.
Using the Chicago Mercantile Exchange (CME) Fed tool (which you can find here), markets appear to think that the odds that the Fed will raise to more than 3.0 percent by the end of next year is less than ten percent.
In fact, the effective implied Fed Fund rate using futures prices is 2.75 percent for 2019 and 2020.
Traders started scaling back expectations about future hikes after an October speech by Chair Powell who indicated that slowing growth abroad, the fading benefit of the tax cuts and monetary tightening are issues that the Fed is watching.
The monetary tightening issue goes beyond the overnight Fed Funds rate, and, importantly, includes what the Fed decides to do with their balance sheet, which still exceeds $4 trillion.
During the financial crisis, when the Fed couldn’t lower rates below zero, they engaged in a process known as quantitative easing (QE), which meant buying bonds in the open market in an effort to drive rates lower.
Prior to QE, the federal reserve had less than $900 billion in assets, but after three rounds of QE, it grew to $4.5 trillion. A little more than a year ago, they started to ‘normalize’ their balance sheet, and it has shrunk a little bit, which can be seen on their website by clicking here.
Even though the QE program is now more than a decade old, we still don’t have a sense of how it ends. It would be nice to know, for example, the level that the Fed would like to target.
Are they going back to a $900 billion balance sheet, or something larger, like a two or more trillion dollars as former Chair Bernanke suggested a few years ago (click here for the article). He even suggested that the economy may grow into the existing balance sheet, implying that they don’t need to shrink it much.
Obviously, a few trillion dollars’ worth of policy decisions will impact the economy and markets.
What the Fed does or doesn’t do with their balance sheet is what you might call an ‘known unknown.’ We’ve known that unwinding the balance sheet would be an issue when it was first created and we haven’t known what the Fed would do ever since then.
Another known unknown surrounds what Fed Chair Powell may or may not do if the market starts to fall more precipitously.
Just after former Fed Chair Alan Greenspan was appointed, the 1987 crash occurred, and Greenspan quickly cut interest rates. He cut them again in response to the S&L crisis in the early 1990s, the Gulf War, the Mexican peso crisis, the Asian financial crisis, the bailout of hedge fund Long-Term Capital Management, and Y2K.
Traders, seeing a pattern, coined the Fed action the ‘Greenspan put,’ which meant that if the market fell far enough, the Fed would bail the market out by providing liquidity. Put options can give investors downside protection if a stock or market index falls below a certain price. While the Greenspan put wasn’t a real put option, investors believed that it had the same effect.
When Greenspan left in 2006, it wasn’t long before his successor, Ben Bernanke did the same thing in 2008, leading markets to change the name to the Bernanke put.
Bernanke’s successor, Chair Janet Yellen, didn’t have the opportunity to implement a Yellen put, but she was considered so dovish by markets that it was very much understood that there would have been a put if markets called for it. The closest that she came to providing a put was holding off an expected hike in 2016 when a selloff in Chinese stocks sparked a global growth scare.
Like Yellen, Powell hasn’t been thoroughly tested yet, but the markets don’t seem to think that he’s as predictable as Yellen. Unlike his predecessors that earned the ‘put’ moniker, Powell isn’t an academic – something that some academics criticized him for when he was nominated.
I could certainly be wrong, but Powell’s Wall Street background may cause him to want markets to run their course without as much government intervention as his predecessors preferred.
We may know more this week since Chair Powell is giving a speech in New York on Wednesday. A few other Fed members will be giving speeches throughout the week, but the reality is that they’ll all speak in such generalities that we may learn a little bit more about December, but probably not much else.
It’s seems likely to me that everyone will keep mum about the balance sheet, and, as for the potential for a ‘Powell put,’ we can only see where markets go and how the Fed responds. As usual, only time will tell.