Don’t Expect A Fed Bail Out: What Convexity Flows Mean For Repricing Of The “Fed Put”

One of the major topics to emerge among financial professionals over the past week in the aftermath of the latest violent market move lower was whether the “Fed Put” would come into play, and at what level, and just as importantly, what happens to markets – both stocks and bonds – as this new put level is repriced by market participants.

As we discussed last Thursday, in one of its questions in the latest Fund Managers Survey released last week, Bank of America asked “what level on the S&P 500 do you think would cause the Fed to stop hiking rates?” What it found is that according to the respondents, the Fed would stop hiking if the S&P 500 fell to 2390, suggesting the “Powell put” strike price is about -12% below current levels.

Other banks also stepped in with: according to BNP Paribas, a 6% drop in the S&P 500 Index to 2,500 would be the resistance level that would prompt a response from Powell. “A 10 percent to 15 percent drop in equities is usually the difference between noise and signal,” BNP Paribas analysts said in a note. Meanwhile, Evercore ISI has put the “Fed Put” below the 2,650 mark.

Other were more skeptical, with BlackRock and River Valley Asset Management say the real economy remains relatively insulated from the stock meltdown. “The correction that we’re seeing in the stock market obviously is something that they pay attention to,” Scott Thiel, deputy chief investment officer for fundamental fixed income at BlackRock in London said in an interview on Bloomberg TV. But “the bar is very high to change Fed monetary policy.”

Andre de Silva, global head of emerging-markets rates research at HSBC, was even more blunt, telling Bloomberg TV on Thursday that the Fed needs something “more dramatic” than a stock rout to convince them to stray off course. And looking at corporate bonds – a key component of financial conditions – where the market rout has yet to inflict much pain, the HSBC analyst may have a point: the spread of junk bonds over investment grade credit has narrowed about 14 basis points this year and has barely budged wider, largely due to a sharp drop off in supply. Another place to look: rate vol, which was remained surprisingly dormant during the latest stock market rout.

All of the above opinions, however, do not change the fact that the recent drop in equities has already led to a substantial tightening in financial conditions. Last weekend, before the latest weekly rout, Goldman analysts calculated that the bank’s Financial Conditions Index (FCI) has tightened by 32bp since October 2, noting that the recent stock sell-off was the major driver of the tightening, as shown in the chart below.

Summarizing these various observations, over the weekend Deutsche Bank’s derivative strategist Aleksandar Kocic wrote that the recent market turbulence has been “predominantly the equity story in response to restriking of the Fed put“, which while affecting all markets, when compared to other sectors, equities continue to deliver outsized moves.

He shows this in the chart below which illustrates the equity- credit interaction, and echoes what Goldman said a week ago, namely that the Fed is tightening financial conditions via equities and the market’s renewed concern about the level of the “Powell put”:

In terms of weekly changes/ returns, both this and last week’s corrections are comparable with the events in early February, when the first restriking of the Fed put took place. In the current context, restriking of the Fed put is a channel through which financial conditions are likely to tighten.”

Another observations Kocic makes is that while for the most part during the Fed’s tightening cycle the Fed has been successful in telegraphing its intentions, two distinct breaks occurred in February during the inverse VIX ETF rout and again in October. It was then that the Fed put was “restruck” with the mechanics visualized in the chart below which shows the S&P in relation to the short rate, in this case manifested by the 2Y swaps rate:

Fed hikes, but adjusts its pace not to derail the stocks — in this way, rate hikes are collinear with the recovery and the risk-on mode. An overly aggressive pace of rate hikes, however, is bearish for stocks. This is what we saw in February and October.

According to Kocic, in the current hiking cycle, equity beta remained unusually high: # = # ln(S&P) /# Yield = 30. Normally, this number is around 10. For the DB strategist, this means that in this cycle, in which monetary policy has been protective of risk post-2014, the “Fed put had been struck very close to ATM.” This also means that for those seeking to estimate the current level of the Fed put, the lowering of said “strike” price, which is consistent with a lower beta, around 20, “corresponds to S&P around 2400.” As a reminder, this is the same absolute strike as what Kocic calculated back in April, but lower in relative terms.

The immediate result of this repricing has two effects: on one hand the Fed provides a traditional backstop to equities, which is also why so many analysts and traders have been so curious to find out what the new level is, or as Kocic writes, “having Fed put in place is like appending an insurance to stocks. Thus, its desirability and price should reflect it”, and putting it in simplistic terms, “Lowering the strike Fed of the put is equivalent to increasing the deductible of the insurance.”

Which bring us to the second effect: having concluded that the Fed put is now at a lower level, it “makes stocks potentially more vulnerable and their price should adjust lower. This is what the market is currently experiencing”, according to the DB strategist.

There are other several other notable downstream effects, mostly as they relate to volatility, not only for equities but also the all-important rates market.

According to Kocic, at the same time as the new equilibrium price is negotiated, “restriking of the Fed put is played out in vol since it represents effectively a withdrawal of convexity from the equities market, i.e. it is a convexity supply shock.”

As a consequence, equity volatility should increase, both in absolute term and relative to volatility of other asset classes. A new equilibrium vol levels is achieved by equating the original put at previous vol levels to the new, lower strike, put at higher vol. A back of the envelope calculation suggests equity vol rise by 5-8% as a result of restriking.

This interplay between equities and rates is shown in the chart below which shows the ratio of VIX / rates gamma and the two points of their reset corresponding to restriking of the Fed put.

Here Kocic touches on a point he made half a year ago, when he notes that with the Fed telegraphing a new, lower Fed strike price, it is very unlikely that the market will sell off in a calm, cool and collected manner from its current level to 2,400; 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 April explanation is 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.

When seen through this feedback loop of convexity flows, by withdrawing convexity from equities, “the Fed is passing it to the rates market by supplying implicit rate caps.” This, to Kocic, is “the long run agenda for rates” where he sees as the main short-term effect likely to be a disruption in pension fund flows, i.e. buying, whose rebalancing on the back of equity outperformance was one of the main reasons for the strong bid for long-end (30Y) Treasurys. And now, a selloff in equities could reduce rebalancing flows and “temporarily withdraw pension funds’ sponsorship. This is the near-term rebound of the risk premium.” Said otherwise, a key question for risk is whether and when the equity vol finally migrates over to the bond market and results in a spike in what has so far been relatively dormant rate volatility.

Ironically, a “shake out” in the long end may be the Fed’s intention in how to further tighten financial conditions.

Picking up on the Goldman calculation from last week, DB economists estimate that a 15% decline in equities has the same impact on financial conditions as a 25bp rates hike, which would also mean that rates could potentially have less need to rise in the future, and with the long-end becoming unhinged, it could lead to further benign curve steepening which would allow the Fed to continue its rate hikes without fears of forcing an imminent curve inversion.

In this context, consider that in recent cycles, the US 10 year has tended to peak at a level close to that at which the Fed Funds rate peaks, as highlighted in the chart below, and in general some 3 to 6 months in advance of the policy rate. What is clearly different about this cycle is that the Fed now provide the market with explicit projections for the policy rate over the coming years, with their latest median projection being that the Fed Funds rate will peak at 3.3% in 2020, only 15bps above the current US 10 year yield. To the extent we can take history as a guide, therefore, the implication here is that – all else equal – there is only limited upside to US 10 year yields. The risk, as Credit Suisse writes, is that the Fed is providing us with projections for the policy path, not promises, and thus uncertainty will persist.

Seen in this light, forcing 10 and 30Yr yields higher may be just the stop-gap solution the Fed needs in order to allow itself breathing room to extend its hiking cycle, which according to its dots will see another three to four 25bps hike before the end of the hiking cycle, an outcome that would be impossible without equity vol spreading to the long end of the curve, and leading to a selloff in the 10 and 30 Year Treasury.

Finally, we come to the more pressing – to some – question whether the recent drop in stocks will be enough to satisfy the Fed that conditions are now tight enough. As noted above, Deutsche Bank economists estimate that a “sticky” decline in the S&P500 to 2450 would be necessary to exert the same drag on the economy through financial conditions as a 25 bp hike.

And whereas traditionally the Fed has stepped in to offset any stock weakness, either through direct action (delaying of rate hikes, or verbal jawboning), this time the imperative for the Fed is different: as Kocic explained above, weaker equities are consistent with ongoing term premium recovery because of the implications for pension investor flows.

Or, in simpler terms, the Fed wants higher long-term yields:

Stable equities slow corporate plan convergence to full funding, and obviate the need to rebalance equity gains into fixed income. Historical evidence suggests that state and local pension investors might “re-risk” on the margin given equity underperformance relative to fixed income.

Which brings us to the big question, namely whether given the recent equity rout, the Fed might deviate from its own median projections to the dovish side.  As the discussion above suggests, which if accurate would imply that the Fed hopes to push yields higher through the equity vol channel, this is unlikely to happen if all the Fed can “force” is a 25bps equivalent tightening in financial conditions (via a 16% drop in stocks).

And sure enough, as we noted late last week, Cleveland Fed President Mester commented on exactly this concern, stating that “while a deeper and more persistent drop in equity markets could dash confidence and lead to a significant pullback in risk-taking
and spending, we are far from this scenario.”

Deutsche Bank agrees, and as its credit strategists argue “tightening financial conditions are one of the policy goals currently being pursued by the Fed to discourage excessive risk taking and promote financial stability.” In other words, don’t expect any rescue from the Fed for another several hundreds S&P points.

The tell? Keep an eye on rate vol: if and when it shoots up, that’s when the Fed may finally panic. And, as BofA’s CIO Michael Hartnett likes to remind his readers, “markets stop panicking when central banks start panicking.”

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