Stocks May Have to Tumble 20% Before ‘Fed Put’ Comes Into Play

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Anyone expecting the Federal Reserve to save the markets is likely to be disappointed unless things get a lot worse.

While yesterday’s 3.3 percent drop in the S&P 500 Index was the biggest since February, 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, according to Krishna Guha, the head of central bank strategy at Evercore ISI.

“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.”

A 10 percent 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 percent plunge would take it all the way down to 2,345, a level not seen since the middle of 2017.

Westpac Banking Corp. Senior Strategist Sean Callow concurred, writing in a note 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.”

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The equity turbulence that shook markets in February — the S&P 500’s worst month in two years — was “genuinely large,” but the Fed still brushed aside suggestions it might turn more cautious on rate hikes, Callow said. He adds that the Fed sounds even more confident about the U.S. economy now than it did in the first quarter.

“RIP the Fed put,” Callow added. It’s “dead — at least for some time, if not forever.”

That isn’t to say some market participants might not welcome a rethinking by the Fed.

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.”

But he doesn’t expect change anytime soon, either, saying policy makers are unlikely to pause interest-rate increases unless financial conditions worsen significantly.

“While the President might believe normalization to be ‘loco,’ that clearly isn’t a view shared by the FOMC,” Lyngen wrote.

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In fact, the Fed might almost welcome an equity pullback. Evercore’s Guha notes that policy makers want to tighten financial conditions, at least to an extent, to achieve a soft landing. And while that doesn’t mean equities have to decline, that could be “part of the mix” along with factors like higher rates, a higher dollar or wider credit spreads.

Guha also sees changes in credit spreads as possibly being more important than repricing of equity markets. Widening in credit spreads has been “visible but not extreme (and might even be welcomed by the Fed on financial stability grounds),” he wrote.

“The Fed will take a holistic view of financial conditions across the term structure of rates/yields, the exchange rate, credit spreads and cost of equity,” Guha said. “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.”


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