How valuable is the Fed put?

After some extreme hawkish-dovish swings between October 2018 and early January of this year, the US Federal Open Market Committee finally acknowledged the reality of what Powell described as ‘cross-currents at home and abroad’ with a decisive dovish tilt in the FOMC on January 30. That it came on the back of little change in the current economic outlook as such is telling – the subsequent strong nonfarm payrolls print propped up the case further still. It wasn’t just a sustained pause on rates that the Fed hinted towards, either – it even left the door open to tweaking the balance sheet run-off, which has been on autopilot mode, ‘if the situation warrants’. It’s fair to say that the Fed put has officially kicked in.

Coming as it does at a time when the significance of the Fed put pales in comparison to the broader slowdown concerns in China, the accelerating slowdown in the European Union and falling US imports, it is hard to make a case for the put as a potent force. While the immediate reaction in risk assets was positive with equities bouncing higher, EM assets rallying and USD weaker, the impact of the Fed put is likely to be limited this time around.

The dollar, for example, has already recovered substantially from the post-FOMC low as the odds of a September hike from the European Central Bank are practically zero in the face of Germany’s growth being downgraded for 2019 to 1.1% and Italy entering recession. As well, the broader EU slowdown is likely to accelerate further through the year. The Reserve Bank of Australia has followed suit by tilting dovish and a woeful labor data release has increased the odds of a Reserve Bank of New Zealand rate cut over the next 12 months.

With that set up, we could see emerging market central banks follow suit as well with India already cutting the rates, Thailand standing pat, Mexico, and, Brazil likely to do the same if not actually cutting rates in the near future. The only central bank with anywhere near the ammunition required to hike rates was the Bank of England but they also grew more cautious in the wake of the never-ending Brexit saga.

In terms of the equity bounce, much of the recovery from the December 26 low was already underway with the SPX up 14.65% from the low on the day before the FOMC. If we have to strip out the dovish Fed’s impact on the index, we could say it was barely 2% of the move. Also, this recovery is built on the premise of a US-China trade deal as much as the likelihood of Fed staying on pause all year.

If the dovish tilt from Fed has had a major impact on one aspect of risk sentiment, it is probably insofar as it has decreased the odds of US yield curve inversion substantially with the 10-year/two-year spread – which converged as closely as within 10 basis points in December – back to 17 bps wider and likely to stay in positive territory as long as the Fed stays on pause. Swaps markets are pricing in the next Fed rate move as a cut rather than a hike.

Germany and other twin surplus economies continue to steer away from fiscal stimulus. China’s monetary stimulus has proven to be too small in size to offset the scale of the slowdown facing the economy – the mirage of a V-shaped recovery can be comfortably thrown out of the window. The US is running out the tax stimulus’ last laps just as the impact of Fed monetary tightening over the last years is starting to show up in housing and other rate-sensitive sectors.

A US-China trade deal could provide a much-needed temporary boost, but the broader demand shock facing the global economy in the later part of 2019 and 2020 is getting increasingly real.

Against this backdrop, the Fed’s dovish tilt (and the likely coordinated pause in monetary tightening from central banks around the world) has come too late and with a rather small scope of course correction. Hopes for a US-China trade deal set aside, it is easier to make the case that we have already seen the top in equities than the bottom.

The Fed may have written a put option but if I had to mark it on the SPX chart, the strike would be closer to 2,300 than 2,700.