COLUMN-The Fed put, 2015 interest rate rise edition: James Saft

(James Saft is a Reuters columnist. The opinions expressed are his own)

Dec 9 (Reuters) - With better and better evidence emerging that the Federal Reserve ought to raise interest rates soon, its much debated, always denied role as guarantor of asset prices will be put to the test.

If this test goes like all of the others, then if markets fall hard, the Fed will step in.

Friday’s U.S. jobs data painted a picture of an economy creating jobs, increasingly professional jobs, at a good pace and with reasonable wage growth. Yet financial markets took the news calmly, despite knowing full well that should the Fed move to hike earlier than expected in 2015, risky assets like equities and emerging markets will almost certainly take a pummeling.

The simplest explanation, investors’ belief in the ‘Fed Put,’ is probably the best. This is the idea that the Federal Reserve stands ready to take steps to rescue markets if they decline sharply, in essence offering investors what is known on financial exchanges as a ‘put,’ the right but not obligation to sell a security below a certain price.

William Dudley, President of the New York Fed, became the latest last week to deny that such a thing exists.

“Let me be clear, there is no Fed equity market put. To put it another way, we do not care about the level of equity prices, or bond yields or credit spreads per se,” Dudley said in a speech.

“Instead, we focus on how financial market conditions influence the transmission of monetary policy to the real economy.”

These protestations are somewhat undermined by recent events, not to mention history and the data.

The most recent equity market palpitation in October was arrested when St Louis Fed President James Bullard deployed the defibrillator by saying that QE3 could be extended.

“Fed officials can confidently say what Dudley said when equities are at record highs,” hedge fund manager Stephen Jen of SLJ Macro Partners said in a note to clients.

“I would take them more seriously if they say things like this in the midst of a 10 percent sell-off in equities.”

On several critical occasions in the last two decades the Fed has eased interest rates or otherwise provided succor to financial markets when they were in distress. This happens not just in times of sharp sell-offs: research from the New York Fed shows that since 1994 equity market returns are essentially flat if you exclude the three-day window around rate decision announcements. (here)


This may well put the Fed in a difficult spot in 2015.

Despite quite low inflation, the overall run of data in the U.S. has been pretty good, and may well continue. Pressure on the Fed to prepare the way for a rate rise soon will mount, something that record-high and still rising equity prices will accentuate.

That’s despite a growing contrast between the U.S. and the rest of the world. In Europe, Japan and China growth is disappointing and central banks are in easing mode.

All of this has helped to propel the dollar’s quite startling rally, as investors put their money where they expect the highest returns.

Should the Fed add to this with hawkish talk or interest rate rises, the dollar’s rise may accelerate and effects will be felt keenly outside the U.S.

The Bank for International Settlements warned in its most recent quarterly report released over the weekend that the strong dollar may pose a threat.

“The appreciation of the dollar against the backdrop of divergent monetary policies may, if persistent, have a profound impact on the global economy, in particular on emerging market economies,” the BIS said.

“For example, it may expose financial vulnerabilities as many firms in emerging markets have large U.S. dollar-denominated liabilities.”

The threat is a self-fulfilling cycle: Fed tightens, dollar rises, emerging market companies find it more expensive to borrow and repay and become less attractive borrowers, prompting loans to get yet more expensive.

Given that offshore lending in dollars has risen sharply and now totals about $9 trillion, this has the capacity to become the kind of problem which might influence the Fed.

What’s notable here is how self-perpetuating the entire mechanism is. Since markets have confidence that the Fed won’t upset the apple cart, borrowers take on risk, in this case currency risk. Since the Fed knows this, and many other examples of the same type of phenomenon, it is inhibited from raising rates and, apparently, willing to clean up if matters get rough.

As it has arguably been for each of the past seven years, at least, the Fed put will be one of the prime movers of 2015. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at and find more columns at (Editing by James Dalgleish)