Investors are starting to doubt whether they can count on the protective embrace of an accommodative U.S. central bank when markets go haywire.
Federal Reserve chair Jerome Powell has said little about the sharp fall in Wall Street stocks this month, besides offering the platitude at his swearing-in ceremony last week that “we will remain alert to any developing risks to financial stability.”
All eyes on testimony
But the spotlight will be on the new Fed chair next week when he faces questions from both houses of the U.S. Congress in semi-annual testimony starting on Tuesday, and his audience will include investors who unceremoniously greeted his early tenure with one of the fastest 10% falls in Wall Street stocks in history earlier this month.
“I don’t think it is a coincidence that this occurred at the same time as we saw the passing of the baton between two different Fed chairs,” said Kristina Hooper, global market strategist at Invesco Ltd., an asset management company, adding that former Fed chair Janet Yellen had “lulled” markets into complacency. Mr. Powell could be very different from Ms. Yellen, she said. The notion that the Fed would always be there to prop up shell-shocked markets prompted the notion of a Fed “put” option under three prior Fed leaders — Janet Yellen, Ben Bernanke and Alan Greenspan. The term is a reference to the hedging strategy of using a put option to guarantee an investor a sale at a preset price to limit losses.
While the Fed did not buy stocks or sell options in response to the 2007-2009 financial crisis, it did push short-term interest rates to historic lows and bought bonds, driving down yields. Starved for yield in recent years, investors were forced into the stock market, driving up valuations, thanks to the Fed’s policies.
“There was definitely a Yellen put, and it remains to be seen whether there will be a Powell put,” said Ms. Hooper.
Ms. Yellen’s Fed did later raise interest rates though, starting in late 2015, but it did so more slowly than in earlier cycles and it backed off when markets were stressed. In 2015 and 2016, the rate-setting Federal Open Market Committee (FOMC) delivered just one rate hike per year.
The Fed now faces pressure to move more quickly to guard against a possible overheating of the economy, as the Fed’s balance sheet and global interest rates still bear the tidemarks of emergency policies. On Friday, the Fed’s semi-annual monetary policy report to Congress, its first under Mr. Powell, said the Fed sees steady growth continuing and no serious risks on the horizon that might make the central bank pause its planned pace of rate hikes.
“This will be one of the more hawkish Feds we have experienced in 20 years,” said Andrew Brenner, head international fixed income, NatAlliance Securities LLC.
Higher interest rates could lure cash out of the stock market and into bonds as yields rise. Higher rates could also tighten credit for consumers as well as companies that have struggled to grow their sales as quickly as their profits during this economic recovery.
“Market participants would rather see the Fed take actions that sustain the expansion, and that means more rate hikes,” said Tony Crescenzi, market strategist at Pacific Investment Management Co.
