Equity investors are once again betting the Federal Reserve will come to their rescue.
The S&P 500 index has rallied in June even as the risk factors that hammered stocks in May — a worsening trade war with China and signs of a softening economy — intensified.
The answer to the apparent conundrum can be found in Fed funds futures, which show investors wagering that the U.S. central bank will lower rates three times this year. The situation is reminiscent of the notorious "Greenspan put," a trading strategy whereby investors used a put option to hedge against downturns in asset prices in the expectation that the then Federal Reserve chairman would come to the market's rescue.
Under Janet Yellen, the Fed sought to reset its relationship with markets by relying on hard economic data to make its decisions, rather than reacting to the whim of markets. But for many investors, the put returned when current Chair Jerome Powell signaled a halt to his rate-hiking cycle in January and a pause in unwinding its balance sheet after stock markets slid in December.
"The Fed, under Chair Powell, has already shown its rapidity in responding to changing market environments, even before clear changes in the macroeconomic data," said Ian Samson, investment research analyst at Fidelity International. "Someone less charitable might attribute this to a lack of a clear guiding framework."
Powell's response to December's sell-off — the S&P 500 dropped 15.7% between Dec. 3 and Christmas Day — has the market betting that May's shaky markets — the S&P 500 fell 6.6% last month — will be met by a response from the Fed.
As recently as mid-April, the CME FedWatch Tool showed investors were not expecting any rate cuts in 2019. Today it indicates they have priced in a 98.6% likelihood of one cut this year and a 53.5% chance of at least three, despite the Fed so far only committing to pausing its rate hiking cycle. The Fed raised its key rate by 25 basis points to 2.25% to 2.5% in December and has held it steady since.
Powell has been backed into a corner by his "bizarre hike and pause" approach, according to Gene Frieda, a global strategist at Pacific Investment Management Co., or Pimco.
Losses in May were triggered by a breakdown in trade talks between the U.S. and China. Worsening economic data has reinforced expectations that the Fed will act.
The Markit Manufacturing PMI fell to 50.5 in May, the lowest level since September 2009, with new orders declining for the first time since August 2009. Jobs data also surprised on the downside. In May, 75,000 jobs new jobs were added to the economy, compared with an Econoday consensus estimate of 180,000, and well down on the year-to-date average of 164,000.
The S&P 500 gained 4.6% in the month to June 12 in anticipation of a more dovish message from Powell. The Fed chair whet traders' appetites when he said June 4 that he would "act as appropriate to sustain the expansion."
The danger of being led by financial markets is that investors are encouraged to take greater risks, potentially contributing to asset bubbles, such as the ones that led to the 2008 financial crisis.
The growing uncertainty around trade gives Powell a justification to cut as he would be able to sell a rate-cut as a pre-emptive measure, but this could embolden a market already "very aggressive" in its expectation of three rate cuts, Commerzbank Global Equities Economist Peter Dixon said.
"Give them a bit of meat and they always want the whole joint and that's the problem we have at the moment," he said.
Much will depend on the progress of trade talks and a proposed meeting between Trump and Chinese President Xi Jinping at this month's G20 heads of state meeting.
"On a gradual U.S. slowing, one-to-two rate cuts is probably sufficient to avoid a recession; in a full-blown trade war it's highly unlikely that's enough," Pimco's Frieda said.
Moreover, Powell's put isn't the only one out there, he said. "One put is the 'Fed put,' the other potential put is the 'Trump put,'" he said, noting that Trump could soften his tone over China once more should the market sell-off too sharply.
"The China stimulus put is also relevant," Frieda said. "If [Chinese] growth drops too low, China could go for another round of stimulus, probably not until after the G20 meeting, but a more traditional stimulus with infrastructure spending."