What the New Role of the Fed Means for Opportunistic Investors

The role of the Fed has been to promote maximum sustainable employment and maintain price stability. For most of the Fed’s history, this role of maintaining price stability had meant that the Fed will take steps to keep inflation around the long-term 2% target inflation rate. But starting in the late 1980s, the Fed has taken action to promote financial markets stability. This marked a shift in the role of the Fed and the birth of what is now known as the Fed put.

The Fed has a few different tools they can use to accomplish their mandate. The most well-known and widely followed is the Fed Funds Rate, which is the base interest rate that banks charge one another for overnight loans. Almost all other rates within markets respond to changes in this rate and trade at a spread on top of this base rate. Through this tool, the Fed can affect the borrowing rates for individuals and companies.

Next, the Fed can conduct open market operations and quantitative easing. This entails the Fed going to the open market and buying Treasuries or other fixed income to backstop a drawdown. While there is evidence of quantitative easing throughout the Fed’s history, it is most closely associated with the Fed’s response to the great financial crisis of 2008 and the risk-taking following this recession.

Finally, the Fed can use Tapering, that is, reversing the quantitative easing, first buying less in the open market, and letting the Fed’s holdings mature and thus shrinking the Fed balance sheet. This is a restrictive tool while quantitative easing is an expansionary tool.

To fulfill the role of the Fed, the chair most often uses the Fed Funds Rate, but particularly during times of market stress, quantitative easing can be a powerful tool leveraged.

It is generally accepted that the first Fed put came following the crash of the market in 1987. Alan Greenspan, the Fed chairman at the time, aggressively cut the Fed Funds Rate, provided banks with repo loans, and bought large volumes of treasury bonds. From this point, the role of the Fed would be debated. The center of that debate hinging on whether part of the Fed’s mandate is to help financial markets maintain stability.

The next instance of a Fed put followed the great financial crisis of 2008. Ben Bernanke who took over as Fed Chair from Alan Greenspan in 2006 cut rates aggressively and instituted similar measures of quantitative easing (QE), initially buying treasuries before expanding the program to include mortgage-backed securities. Following this action and leading into the tenure of Janet Yellen and now Jerome Powell, the Fed put has become something that investors come to expect. Following the COVID-19 market drawdown, for example, Powell quickly cut rates and instituted quantitative easing-like activities making purchases in the bond market to help stabilize markets. Markets have been very responsive to these actions, using the same example, the market rebounded extraordinarily quickly following the initial COVID-19 drawdown. These actions, which at one time were considered extraordinary, have become taken for granted by investors; when there is market stress, many expect that if things become too dire, the Fed will step in. Whether or not the Fed would codify its focus on stabilizing financial markets into its mandate, it is impossible to deny that the role of the Fed has shifted. The Fed put has transformed how investors need to think about investing during times of market stress.

Now that the role of the Fed has expanded and they are focused on financial market stability, it is probable that opportunistic investors need to act quicker during market drawdowns when valuations become attractive.

There are many managers, including several managers on the Crystal Capital platform, that historically have generated outsized returns by deploying capital during sharp market drawdowns, while we certainly cannot guarantee these returns moving forward, there are reasons to believe that this theme may persist. These strategies hinge on security selection and market timing. Decisions around market timing need to evolve to take into account the now consistent Fed put and expanded role of the Fed. It is reasonable to believe that markets will rebound more quickly once the Fed steps in based on the belief that the Fed will take extraordinary action to support financial markets (like it has done in the past) and that markets will likely not experience as dramatic drawdowns once again based on investors’ perception that the Fed will keep markets from experiencing bouts of stress.

While market drawdowns have become less extreme, the data shows that drawdowns are happening with more frequency. There is much debate that the frequency of the drawdowns may be a symptom of widespread investor risk-taking resulting from the expanded role of the Fed and quantitative easing but it is challenging to draw clear conclusions. What is clear is that the expanded role of the Fed has reshaped investor expectations, and now, in all times of market stress, there is an expectation that the Fed will step in. So, while we may never see a drawdown that resulted in the highly attractive valuations of 2008/09 again, there have been and likely will be more, quicker, and less extreme drawdowns. It follows that opportunistic investors will have to be more prepared to act quickly and aggressively during these times of market stress.

Many of the managers on the Crystal Capital Partners platform have historically generated their compelling track records by earning outsized returns during and coming out of times of market stress. The new role of the Fed has changed how markets behave during these times of stress, and thus has changed how hedge fund managers respond. We expect to see our managers act more quickly and more aggressively to drawdowns, rather than patiently wait for the bottom. After all, recent history has taught us that the Fed will likely step in and a rapid rebound in valuations will follow.

Sources:

1. The Federal Reserve's Dual Mandate - Federal Reserve Bank of Chicago (chicagofed.org)
2. Greenspan Put: Definition, Examples, Vs. Fed Put (investopedia.com)
3. The 'Bernanke Put' (bushcenter.org)
4. The Federal Reserve's Dual Mandate - Federal Reserve Bank of Chicago (chicagofed.org)
5. What's in the Fed's Toolbox? | Charles Schwab