What the death of the “Greenspan put” means for investors

The Federal Reserve, America’s central bank, raised interest rates in the US by three-quarters of a percentage point yesterday. That’s the second month in a row. The federal funds target rate is now 2.25% to 2.5% (it’s a range, rather than one number as with the Bank of England).

Once upon a time, not so very long ago, the idea that the Fed would be pumping what the market once viewed as six months’ worth of rate rises into just two months would have had people expecting the end of the world.

And certainly markets haven’t exactly been enjoying the ride. But the Fed has persisted.

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Thing is, yesterday, alongside the 0.75 percentage point rise, we also got a whisper of a hint that the Fed might decide to ease up a little, depending on what happens next.

To be more specific, Fed boss Jerome Powell said “it likely will become appropriate to slow the pace of increases”.

That hint was sufficient to send the S&P 500 up 2.6% and the Nasdaq up by 4.1%.

The thing is, though, Powell also warned that “another unusually large rate rise” could be appropriate too, depending on the data.

So is the market falling for wishful thinking? I can’t help but think that it might be. Here’s why.

The Fed now feels financially omnipotent

I was listening to Bloomberg’s Odd Lots podcast yesterday. The guest, former senior Federal Reserve trader Joseph Wang, made a point which really made me rethink my view on central banks.

Here’s a bit of context.

For decades now, the core assumption about central banks is that they will intervene in markets if they fall fast enough or far enough. This tendency was best known as the “Greenspan put”, after Alan Greenspan, the Federal Reserve chair who first put it into practice. It was never official policy, but Greenspan’s habit of cutting interest rates at any sign of trouble certainly bred an element of complacency.

This belief that the Fed has a pain point at which it will act to “save” the market is still apparent. Investors keep thinking that a turning point is coming any time now, which explains why they all alighted on Powell’s words.

But why did the “Greenspan put” exist in the first place? It was because Greenspan was worried about systemic threats. For example, hedge fund LTCM was bailed out in 1998 because of Greenspan’s fears that a collapse of the highly-leveraged fund would create a chain reaction and bankrupt most of Wall Street.

In 2008 we had the financial crisis, and the Fed learned the hard way that some institutions were too big to fail. As a result, in the decade following, the Fed made sure it only took baby steps and tried never to do anything to take the fragile market by surprise.

But all through this process, the central bank was creating more and more systems by which it could intervene more and more aggressively and in more and more markets. By the time the 2020 pandemic panic came round, the Fed was able to declare that it would literally buy junk bonds, effectively scrapping bankruptcy (should it wish). Using swap lines, it also did a great deal to prevent overseas markets from blowing up.

So in effect – and this is Wang’s point – the Fed now feels powerful enough (and you can see why) to be relatively confident that no crisis can be big enough to be systemic anymore.

The “Greenspan put” created massive moral hazard. The fact that the market could rely on being bailed out every time it took too many risks and took things too far, meant that it just kept on taking risks and pushing things too far.

The irony now is that, having underwritten everything, the Fed may have created a different kind of moral hazard. It now feels that it can stop any crisis in its tracks. And as a result, it can raise rates as much as it likes (or at least as much as it takes to tackle inflation) without breaking anything.

In turn, that implies that the Greenspan put is not only dead and buried – it implies that the Fed no longer really cares about the market reaction except in as much as it either tightens or loosens financial conditions.

Something always breaks

That’s a very different world for investors to be operating in – an actively market-hostile (or at least market-agnostic) Fed rather than one which is pandering to every panic and tantrum.

Perhaps more importantly – something always breaks. Not sure what it would be this time around, but something in currency markets (if the dollar keeps surprising everyone) or sovereign debt markets (as Jonathan Compton wrote in a recent issue of MoneyWeek, we’re overdue a wave of defaults) seem likely candidates.

We’ll see. In any case, for now, markets might keep bouncing given the grimness of sentiment out there. But I’d be surprised if the Fed is pleased about the reaction to yesterday’s press conference. The reality is that until inflation shows genuine signs of coming under control, the bias towards tightening won’t relax – and if markets don’t get the message, the Fed might have to act even more aggressively.