Markets Are Focused On The Wrong Fed Put

With equities reeling from the ‘perfect storm’ of synchronized (inflation-battling) global tightening monetary policy, geopoilitical risk, and extreme asset valuations, investors are looking to recent history and banking on a Powell Put being unleashed sooner rather than later to “save the world” once again.

Global rate hike expectations for the rest of 2022 have kept racing higher and now sit at a post-GFC record…

That means the most important question for investors is whether the market can sustainably rally without testing the Fed put and, if not, where the Fed put is struck; that is, as BofA’s Global Equity Volatility Insights report asks (and answers) – what level of financial stress (and which assets) would get the Fed to backtrack on their aggressive tightening plans.

While most focus on the equity drawdowns as the ‘triggering’ event (down 20%, 30%?), BofA looked back at the 3 main occasions post-GFC in which financial market stress caused the Fed to delay tightening plans: Jun-13 (post taper tantrum), Aug-15 (Yellen delaying 1st hike in cycle), and Dec-18 (the “Powell pivot”).

The analysts found that IG credit spreads had widened to very similar levels in each of the 3 episodes by the time the Fed blinked, more so than HY spreads, the VIX, or rates volatility (the MOVE index).

BofA notes that IG spreads were also very tight during the Feb-18 risk asset selloff, even as equity and rates vol spiked. That episode was effectively ignored by policy makers, reinforcing the case for investment grade credit as the best signpost of incoming Fed support.

Simply put, credit is still trading far too tight for The Fed to worry.

At 66bps IG spreads remain far from where they were in prior dovish Fed pivots, in the 90-100bps range), and the highest inflation prints in 40yrs may only push the Fed put strike wider in credit terms.

As BofA notes, FOMC speakers’ hawkish rhetoric and lack of regard for the YTD risk asset selloff are consistent with our analysis and suggests the equity market is far from being rescued.

Based on Q4 2018’s flip-flop analog, spreads need to almost double from here before triggering The Fed Put… that could knock another 15% off the S&P 500 (to 3800)…

This in turn leaves equities exposed to larger downside than upside risks.

BofA suggests ‘put flies’ on S&P screen attractively and can be struck to cheaply hedge a selloff of those characteristics with limited risk, while put spread collars continue to line up well if initiating in a rally.

Trade: buy the SPX Apr 4200/3900/3600 put fly (+1x/-2x/+1x) for $27.5 or 0.62% of spot, ref. 4401.67. The risk is limited to premium spent.