fbpx

Fed Put

The Fed Put is the belief that the US Federal Reserve will step in to rescue the markets if prices fall too much

What is the Fed Put?

The “Fed Put” is a commonly used term in financial markets to describe the belief that many market practitioners hold that the U.S. Federal Reserve (the Fed) will step in with accommodative monetary policy to buoy markets, specifically the U.S. equity market, if prices fall too fast too quickly.

Fed Put

Summary

  • The Fed put is a belief by financial market participants that the Federal Reserve will step in to buoy markets if the price of markets falls to a certain level.
  • Fed puts have occurred throughout history, such as in 1987, 2010, 2016, and 2018.
  • The Fed put is not a confirmed notion by the Federal Reserve themselves. As a result, there are no specific conditions that must be met for a Fed put.

Understanding the Fed Put

The Fed’s dual mandate

The U.S. Federal Reserve operates under a dual mandate from the U.S. Congress to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” It generally involves:

  • Setting accommodative monetary policies during a business cycle downturn to encourage consumer demand by increasing money supply; and
  • Setting restrictive monetary policies in a late business cycle to moderate inflation by restricting money supply.

Not a policy but a widely held market belief

Although the Federal Reserve does not have a Congressional mandate to support financial asset prices, it has become widely accepted by financial market participants that the Federal Reserve would step in should there be strong financial market distress. This is what is termed the “Fed Put,” in which market participants believe that the Federal Reserve will step in to buoy asset prices, specifically U.S. stocks, if they fall too fast.

How Would It Work?

Since this is not a Fed policy, there is no set playbook by which the Fed will enact the “Fed Put.” However, historically the Fed would most likely begin by using its officials and the Federal Open Market Committee (FOMC) to calm down the market through their scheduled speeches, press conferences, and appearances at other public events, such as investor conferences.

Should this not calm the market, the Fed may enact different quantitative easing, asset purchase, or other liquidity facilities to bring stability to the asset markets.

As a last measure, the FOMC might lower its policy rates, such as the Federal Funds Overnight Target Rate (Fed Funds). This is really a last straw option as the Fed Funds is often likened to a very blunt instrument that is difficult to reverse and may carry unintended consequences.

Why is It Called a “Put”?

The Fed put is a play on the option term “put,” which acts as a form of insurance. A put option on an asset is defined as a contract that allows the holder of the put the right, but not the obligation, to sell the underlying asset at a pre-specified price before or at a predetermined point of time in the future.

Any accommodative action by the Fed, real or just verbal, has the strong possibility of helping the financial market recover, or even rally. So you might say that if the Fed enacts the “Fed Put,” the investor’s downside risk is covered, just like they would be if they actually owned a protective put.

Fed Put - Long Put Option Payoff

As you can see from the diagram above, being long a put essentially protects, or hedges, the holder of the put option from a fall in the price of that underlying asset. The way that works is because the holder of the put option can choose to instead sell, or put, the underlying asset to the seller of the put option at the predetermined price, or strike, should the market price fall below the strike price.

Historical Examples of the Fed Put

History has shown that the Federal Reserve has intervened in the wake of significant financial market distress. With that said, it is important to note that the Fed put is not a confirmed notion by the Federal Reserve themselves but rather a belief by financial market participants. As a result, there are no specific conditions that must be met to trigger a Fed put.

Below are some examples of Fed puts throughout history:

  • In the Black Monday crash of autumn 1987, when the Dow Jones fell by 508 points (22.6%) due to hostilities in the Persian Gulf, fear of higher interest rates, and the introduction of electronic/program trading. The next day, the Federal Research intervened by affirming its readiness to serve as a source of liquidity to support the economic and financial system.
  • During the 2008-2010 Global Financial Crisis, the Federal Reserve reduced interest rates and conducted quantitative easing. With the economy recovering, in June 2010, the Federal Reserve attempted to scale back monetary policy by bringing its quantitative easing program to a close. It, however, caused market jitters, causing the Federal Reserve to introduce a new quantitative easing program (called QE2) to soothe financial markets.
  • In late 2015 and into early 2016, the value of stock prices globally sold off due to slowing growth in the GDP of China, falling oil prices, the Greek debt default in 2015, a Brexit vote announcement, and implications of the effects of the end of quantitative easing in the United States in October 2014. In Q1 2016, the Federal Reserve directly invoked monetary tools to help prop the markets.
  • In 2018, the Federal Reserve was raising interest rates and commencing quantitative tightening. The move was poorly received by the markets and even drew criticism from then-president Donald Trump. In 2018, the S&P 500 ended down 6.24%. As the markets continued to wane in mid-2019, Powell provided large-scale repurchase agreements to U.S. investment banks to boost falling asset prices.

The Fed Put and Its Impact on Market Expectations

The market’s belief in the notion of the existence of a Fed Put creates a moral hazard. That means that an investor may freely take on risk but not bear the consequence of any fallout from that risk, as it is borne by another party. That’s the expectation that the Federal Reserve would bail out any significant decline in asset prices.

Experts have argued that this belief has spurred a high level of speculation in financial markets, resulting in the 1998-2000 Internet bubble and the run-up in asset prices before the 2008 Global Financial crisis. A common term used in the financial markets is “don’t fight the Fed,” which implies not to sell or short assets as the Fed would come to the rescue. It has fueled the proliferation of dip buyers whenever financial markets face a significant fall in prices.

Will There Be a Fed Put in 2022?

So far in 2022, equity markets have suffered. Partly due to geopolitical tensions stemming from Russia and Ukraine and partly due to worries about a recession, this fall in equity prices has spurred speculation that there will be a Fed put in the near term to bail out markets. For example, in a survey conducted by Bank of America, respondents believed there would be a Fed put if the S&P 500 continues its descent to reach 3,700.

However, the problem with 2022 is that inflation has been at the highest in recent history. Partly due to supply chain issues stemming from the COVID pandemic and partly due to the same Russian-Ukraine war, inflation running out of control has been one of the most significant fears for the Fed.

As such, the Fed has been very hawkish. Beginning with a somewhat surprising 75 basis point hike in June 2022, Fed Chair Jerome Powell has signaled more aggressive hikes in the second half of 2022.

Therefore, this strongly suggests that the Fed will not be able to quickly pivot from its very restrictive monetary policy stance to an accommodative, or dovish, stance in the short term, all but eliminating the chances of a Fed Put in 2022.

Additional Resources

Thank you for reading CFI’s guide to Fed Put. To keep advancing your career, the additional CFI resources below will be useful:

Financial Analyst Certification

Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes!

0 search results for ‘