Bank of America believes that the Fed will really begin to “capitulate” to raising interest rates when market illiquidity has accelerated to the point that even the Fed can’t ignore it.
When will the Fed trigger its put options? Bank of America pointed to the metrics that need the most attention.
In the current market views on when the Fed will pause interest rate hikes, the most discussed is the strike price of the Fed put options (that is, the point of the S&P 500 index when the Fed is forced to rescue the market).
Despite the market’s long-awaited rally following seven straight weeks of near-record losses in the S&P 500, the Fed has so far offered no help to risk assets and is far from triggering the put.
In its latest weekly report, Bank of America analyst Gonzalo Aziz warned that risks in financial markets are still building to a degree that the central bank has not allowed in the past few years.
The most reliable measure of Fed intervention in history, the corporate credit spread, has reached levels seen before the Fed started pumping water. Moreover, before more than 85% of the Fed’s dovish turn over the past 50 years, its stock declines were less volatile than they are today. Liquidity in S&P futures has only gotten worse amid the global financial crisis and Covid-19, increasing the risk of fragility and the likelihood that the Fed will be tested in dysfunctional markets.
Despite these growing risk factors, Powell has so far ignored all calls from the market. Of course, no matter how hard the Fed tries to signal the opposite, the Fed’s put options are still being tested by the market, as has happened since Greenspan launched monetary policy in 1987.
So what indicators should investors be watching when the Fed is about to take action? Bank of America pointed to the following four key metrics to watch closely.
1. Credit pressure
Credit stress has been the most consistent predictor of a dovish Fed turn over the past decade, especially on investment-grade bonds.
Historically, these bonds have often been used by companies to fund buybacks, if not for the large capital expenditures required. This is especially notable as the CDX IG (the credit default swap index for investment-grade bonds) is now approaching these key historically consistent levels , but the Fed’s focus on inflation means that, before triggering their policy response, Spreads could widen further.
2. S&P 500 retracement
Perhaps as important as emerging credit stress, Bank of America believes that the magnitude of the stock market’s pullback from its all-time highs has been an important signal for investors looking to buy the dip in recent years .
But while this may be relatively effective in an era when the Fed is highly market-sensitive, it has been less reliable in its prediction of a dovish Fed turn over a longer period of time.
As you can see in the chart below, during the S&P’s declines — varying in magnitude, from 2-3% in the mid-’90s to over 30% in ’75 and ’87, the Fed either stopped raising rates or started cutting rates altogether. .
3. Economic data
Economic data is critical to the Fed’s response function, with continued cooling in inflationary pressures arguably the most likely data point to slow its tightening program.
The Bank of America interest rate team pointed out in its weekly report on May 20 that the Fed’s policy shift requires a significant slowdown in labor market data.
On the other hand, asset management company PIper Sandler recently issued an announcement on layoffs, and the large-scale layoffs of enterprises have clearly begun. Bank of America expects the U.S. labor market to cut “1 million jobs or more,” which will be enough to force the Fed to adjust policy.
4. Failure of the market mechanism
While all of the above is undoubtedly an important catalyst for the Fed to start “panic” and capitulate to rate hikes, derivatives traders at Bank of America see a dysfunctional market mechanism as the most likely trigger for a policy shift by the central bank .
Michael Hartnett, chief investment strategist at Bank of America, once said: “When the central bank starts to panic, the market stops panicking.” But it takes more market panic today before the Fed starts to panic about raising interest rates.
It’s not there yet, but it’s getting closer: U.S. stock index futures are approaching record-low liquidity, a key feature of market vulnerability shocks. Because of the relatively orderly pace of the stock market sell-off so far this year, that potential risk is higher for now.
Before 85% of the Fed’s dovish turning moments over the past 50 years, the stock sell-off was less volatile than it is today.
That said, while the Fed may need lower inflation and higher unemployment to open the door for a dovish turn – which would quickly cap high beta growth stocks and cryptocurrencies, prompt the Fed to push for rate hikes The actual catalyst for the capitulation may just be a market crash, where illiquidity has accelerated to the point where even the Fed can’t ignore it.
Last but not least, the Fed’s actions aimed at saving markets may not dampen volatility or create rallies that last to new highs, as they did in 2013, 2015 and 2018, Bank of America strategists said. If inflation remains a pressing concern, Fed intervention may only temporarily ease pressure on risky assets.
While the Fed has so far held back, Bank of America believes the market will continue to test the Fed’s monetary policy, but they warn that the Fed will need more market panic before it really begins to “capitulate.”
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