When we were discussing the self-reinforcing dynamics of vol-neutral funds yesterday, which may or may not continue selling today depending on what the VIX does, we concluded that aside from the decision-making mechanics of systematic funds, the biggest question would be if the Fed, or other central banks, do not do step in to prop up the market as they have on every other similar occasion in the past 8 years.
Would that imply that traders - be they CTAs, risk-parity, or simply carbon-based - are finally on their own?
According to a follow up note sent overnight by Evercore ISI's Krishn Guha, the answer is yes... at least for the first 10% of any upcoming market drop. As Guha writes, "with the US equity market sell-off intensifying Wednesday afternoon, a number of clients have asked at what point the Fed would ride to the rescue. Our answer is that this time the cavalry is not coming — at least not unless we see something much larger — at least a 5 - 10 per cent type correction and maybe not immediately even then.
Clients need to rely on their own hedging and risk management strategies, not assume a public put that is anywhere near the current spot price. Indeed Fed officials might even welcome (within reason, it would be unwise to push this too far) the opportunity to disabuse the markets that such protection exists.
Somehow we doubt that after 8 years of propping up market, the Fed will suddenly walk away, but who knows: maybe this time it is different.
His full note below:
IF MARKETS WEAKEN FURTHER, DON’T EXPECT TO BE QUICKLY BAILED OUT BY THE FED
With the US equity market sell-off intensifying Wednesday afternoon, a number of clients have asked at what point the Fed would ride to the rescue. Our answer is that this time the cavalry is not coming — at least not unless we see something much larger — at least a 5 - 10 per cent type correction and maybe not immediately even then. Clients need to rely on their own hedging and risk management strategies, not assume a public put that is anywhere near the current spot price. Indeed Fed officials might even welcome (within reason, it would be unwise to push this too far) the opportunity to disabuse the markets that such protection exists.
To be very clear we are not forecasting a market correction; markets have shrugged off political woes before, the cushion from a weaker dollar and very low ten year yields provide some support for valuations, and a moderate but persistent step-up in volatility need not generate a large sell-off from here. We do however fear that there is a gap between market expectations and likely Fed behavior that could intensify any correction that did take place at the point at which market participants realized that expectations of early Fed support were not valid.
In our view the right way to think about the so-called “Fed put” is as follows. There is no direct Fed put in the sense that even those policymakers who are sensitive to market developments do not view a given value of the equity market as a goal of policy or as a necessary condition for achieving the macro goals of policy (full employment and 2 per cent inflation). There is however an indirect and partial Fed put in the sense that policymakers do respond to shocks — including from sudden large declines in the stock market — to the extent that these shocks threaten the achievement of its macro policy goals, and these actions tend to be stabilizing to markets.
The Fed macro put is time-varying with respect to equity market prices. First, the Fed is more sensitive to equity market declines — as to any other form of negative shock — when it is pinned against the zero bound on rates as was the case for most of the past decade but is no longer strictly the case today. Second, the Fed is more sensitive to equity market declines when weakness is sustained, pervasive across asset classes (credit as well as equity) and geographies, and appears associated with real economic developments that threaten a marked deterioration in the outlook and balance of risks that could in turn be compounded by market weakness — as was the case in early 2016 but is not obviously the case today.
As we wrote earlier this month we believe that the factors that caused the Fed to appear skittish in 2015 and 2016 — weak and fragile global growth, extreme dollar strength and associated tightening in financial conditions, pronounced weakness in indicators of inflation expectations and the paucity of plausible upside risks — no longer apply in force today and the Fed is therefore likely to appear more resolute, both with respect to soft patches in the data and any equity market sell-off.
Of course as with soft patches in the data this is not an absolute statement: a large enough and persistent enough decline in the equity market and associated loss of wealth and tightening of financial conditions would obviously have implications for the Fed policy path. However, the FOMC is likely to take a longer-range view than most market participants as to what the benchmark for this evaluation should be. If the S&P 500 fell another 5 per cent it would “only” be back where it was at the time of the December FOMC meeting, since when the dollar has weakened appreciably; even a 10 per cent decline would “only” wipe out the gains since the day before the election. It is not obvious that either consumption or investment were highly sensitive to those moves on the way up, though it is certainly possible that they could be more sensitive on the way down.
Faced with a 5 - 10 per cent equity market decline that appeared driven by a correction of excessive valuations and fiscal policy hopes rather than a more troubling deepening of what the Fed currently assesses to be transitory early year economic weakness, we think the Committee might well still move forward with a June rate hike. The Committee is not so far from the zero bound that it could prudently be too dismissive of an equity market correction and might at that point underline that subsequent tightening would be conditional on the economy continuing to evolve broadly in line with its expectations. But if the macro data on payrolls, unemployment, activity and inflation in the period running up to September indicated that the economy had firmed up following the soft patch in Q1 with relatively little sign of drag from the equity market correction, a September hike, December start to balance sheet roll-off and some further hiking in 2018 would remain plausible — even if there would probably be a little less cumulative hiking over this period than would have been the case with a more robust equity market