Three “rules” I learnt almost thirty years ago still hold true today: (1) Don’t fight the Fed, (2) The Fed targets asset prices even though they won’t admit it, (3) The market will test the Fed’s resolve.
I believe the truth of the first two statements has been verified yet again over the last month given the equity market volatility and the Fed’s reaction to it. When Fed Chairman Powell let his hawkishness slip out in early Fall 2018, the market tanked. After seeing an almost 15% selloff in the S&P 500 in December, the “strike” of the Fed’s put was uncovered. The Fed, almost on cue, started to talk back its hawkishness and appeared to adopt a new mantra of “data dependence” instead. Clearly this was exactly what the market wanted and expected, as it rallied almost 10% off the lows in a matter of weeks (Source: Bloomberg).
As the market action forced the Fed to capitulate, the “Rookie Mistake” was corrected and apparent catastrophe was averted… Eurodollar Futures markets immediately took out almost fifty basis points of tightening expectations planned for the rest of this year.
Where do we go from here?
Note that the third “rule” is still pending. The market will need to test the will and ability of the Fed’s tactics and guidance in the days and weeks to come.
If risk markets rally from here and policy makers do not start slipping back into hawkish talk, we could be off to the races, since the market will ride the virtuous cycle of easy financial conditions for a while (of course the usual increase in moral hazard and risks of excessive speculation and its possible aftermath will likely become relevant for risk managers).
For real-time diagnostics on this, consider watching how quickly the December Eurodollar rate futures contract re-prices Fed tightening policy prospects. If market stabilization encourages the Fed to start regaining and re-asserting even mild hawkishness, I expect the market to test the December lows again to see if the “strike” is still there. Without much else to go on at the moment, I would venture that the put is indeed still there and Fed speakers will try to reassure markets of this fact.
To show how Fed tone relates to BTD, let me use a little bit of option math and pose a hypothetical. Instead of thinking of the Fed “Put” qualitatively, think of it as a real option, with all the characteristics that a real option has. Assume that the horizon of this put is about a year (to the end of 2019). Also let us take the “strike” to be at 2350 (the recent low in the S&P 500). The price of this option as of this writing is about 3.5% (Source: Bloomberg). So a seller of this option obtains a “yield” of about 3.5% if the option expires worthless. Coincidentally, it is just a bit more than what any maturity Treasury bond offers today.
To handicap the odds, note that the delta of this option is -0.25 (Source: LongTail Alpha) , or there is only a one in four chance that the market will end the year below 2350 from here. By the way, implied volatility in the market for this option is about 20%, which is right at the average level of realized volatility in the S&P 500 over a very long history. Everything appears normal and very average at the moment, though it does not feel so after the last three months!
Let us switch our perspective now to the investor. If the investor believes the Fed, then he has some assurance that the market will not fall below 2350 (it obviously could, since the put is only a construct, not actually there). So as soon as the market sells off, it makes rational sense to rebalance back by buying the equity market.
If we believe the first rule above about not fighting the Fed, then as with Pascal’s famous wager, we are better off acting as if we believe in the Fed’s powers. In other words, with this belief the holder of a long “put option” should rationally buy the dip. So a “Fed Put” equates to “BTD” under these assumptions. QED.
If you agree with this line of reasoning, then the “Death of BTD has been greatly exaggerated”. As long as the Fed is putting a floor on the equity markets, buying the dip is the rational strategy. This also effectively puts a ceiling on both implied volatility and realized volatility. This is because the act of buying the dip truncates possible fat tails. As the ultimate provider of liquidity, we simply have to accept the fact that the Fed has almost unlimited ability to sell volatility by providing “The Put”. And taking its direction from the Fed, this dynamic has the potential to jump-start the currently dormant “short-volatility” complex: the ecosystem of varied investment strategies from risk-parity, to trend-following, to loans, to high yield, to uncovered option selling, to maybe even “short-volatility” ETFs. And yes, it may likely be taken again to excess and latecomers will suffer the consequences of the bust.
Now let us go back and see if we can poke some holes in our first two cardinal rules. Can we really believe the Fed? Does the Fed really target asset markets?
We can never really be sure that the future response function of the Fed will be the same as the past. Obviously this is why the third “testing” rule exists. This is also why bringing in new policy makers is usually accompanied with heightened market volatility. A changing and challenging political climate is also reason to believe that the way rules are followed this time could be different than in the past. Or it could be due to the interaction of a plethora of other issues: trade wars, negative yields in Europe, market microstructure. Unfortunately we do not have access to any grand theoretical models, only anecdotes of past behavior and a relatively flat distribution of potential outcomes.
Frustrating as it may be, as real-world market participants, not knowing the future and not having a great model of the world is not all bad, because we can still manage the risks of our investment portfolios. As a player-referee, the Fed driven selling of volatility creates the liquidity and market pricing for investors to avail themselves of downside protection at attractive prices. Today, the receding volatility because of the Fed’s new found dovishness is providing a window of opportunity “just in case” the Fed Put’s strike turns out not to be where the consensus thinks it is.
This piece was originally published in Forbes.com on January 18, 2019.