The Fed Put is the belief that the US Federal Reserve will step in to rescue the markets if prices fall too much
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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.
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:
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.
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.
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.
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.
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:
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.
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.
Thank you for reading CFI’s guide to Fed Put. To keep advancing your career, the additional CFI resources below will be useful:
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Next, we will do a quick refresher on central banks and monetary policy before we dive into specific examples such as the Federal Reserve (the Fed), European Central Bank (ECB), Bank of England, and Bank of Japan, and discuss these institutions and their policies in detail. After having learned about central banks, we will go back to economic indicators and give examples of some of the more important ones to be familiar with, such as gross domestic product (GDP), Consumer Price Index (CPI), Purchasing Managers’ Index (PMI), and building permits. Finally, we will end the course by discussing the impact on markets and how they should react to economic news vs. how they react in real life.
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