BNY Mellon: The Fed Put and Realized Volatility

11 januari 2019

By Simon Derrick, Chief Currency Strategist, BNY Mellon

By Simon Derrick, Chief Currency Strategist, BNY Mellon

After the precipitous declines on Monday, October 19, 1987 - the DJIA dropped 22.6% - and before the opening of financial markets the next day, the Federal Reserve issued a short statement: "The Federal Reserve, consistent with its responsibilities as the nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system".

Whether or not this was the catalyst behind the market's subsequent recovery (alongside the Fed’s use of open market operations to drive interest rates down by more than 50 bps on the day to below 7%), this marked the start of an era during which investors came to believe in the power of central banks to manage severe market downturns.

Quite when the phrase "Greenspan put" first emerged remains open to question. However, what is clear is that by 2001 many believed the “put” existed.

The dynamic is easy enough to see. Once investors became convinced that the Fed put existed then the logical response was to take as much risk as reasonably possible, certain in the knowledge that the central bank would be there in the bad times to minimize the losses with ever easier monetary policy settings. 

It’s arguable that in the aftermath of the 2013 “taper tantrum” the put has become even more pronounced, as the Fed became sensitive to the potential impact of, firstly, winding up its asset purchase program before then commencing on balance sheet reduction. Early 2016 provided as good an example as any of this.

The most recent example of the put began to emerge in November of last year in a “conversation” between Fed Chair Jerome Powell with Dallas Federal Reserve President Robert Kaplan.

It was expressed most clearly in recent days by the Fed’s Eric Rosengren when he noted that he had to “take financial market considerations into account” when forecasting the outlook for the economy (and, therefore, the path for monetary policy).

There is nothing particularly surprising about the idea of the put.

However, it does makes it easier to understand why, a decade on from the global financial crisis, official interest rates in Japan, continental Europe and Sweden all stand below zero, developed world central banks buying their own government's debt is considered relatively commonplace and even the idea of a central bank becoming a major shareholder in a wide range of listed companies is becoming normalized.

The question now, therefore, is not how the authorities might react to a sustained downturn in financial markets (that seems clear enough given the evidence of the past two decades) but, rather, how might currency markets react should central banks return to - or even hint that they are considering - increasing their balance sheets once again (the BOJ never stopped of course).

An argument can certainly be made that such moves could lead to a rise in realized volatility as investors become increasingly reluctant to hold impacted currencies.

However, the evidence of the past two decades is that the opposite has ultimately happened when central banks have turned the taps on (see chart below).

While Fed vice chair didn't discuss returning to QE in his comments yesterday, he did indicate that the FOMC would be prepared to change the pace of balance sheet reduction should the circumstances warrant it. It's therefore interesting to note that while certain currency pairs made healthy moves in the aftermath of his comments (USD/CNY most obviously), the price action in more mainstream pairs proved rather more muted. While hardly significant evidence of the impact on realised volatility of QE, it's a very small indicator of the point in question.