Jan 16 (Reuters) – Equity markets have moved from depending for support on the "Fed put" to banking on a "Trump put" of assumed fiscal stimulus, deregulation and tax cuts.
Only one of these two "puts" has a multi-decade track record of dependability, and it is not the policies or person of the incoming US chief executive.
Using the financial contract of a put, under which one party agrees to sell a security at a pre-agreed price to a counter-party, as a metaphor, the Fed put describes the faith investors have had that the U.S. central bank would respond to falls in stock prices with easier money.
That faith has been well earned and well rewarded, as successive Feds have effectively bailed investors out of pickles like the dot-com bubble and the great financial crisis which they might well have otherwise seen coming and avoided, thus making it less potent.
Perhaps it is just that equity investors are used to the world having their backs, but something analogous seems to have recently developed, a belief in a Trump put, under which investors are moving to price in benefits they assume his policies will bring with scant regard to the costs or risks.
One of the best ways to illustrate this is to look at the very low levels of volatility in equity markets and the strong contrast with high and rising trend volatility in foreign exchange and bonds.
The CBOE VIX index of S&P 500 equity volatility, sometimes called the "fear gauge", hit its lowest level since 2007 on Friday and is down almost 35 percent since the end of September. That compares with the strong upward trend in the Deutsche Bank Currency Volatility Index (CVIX) which is now higher in comparison with the VIX than ever in the 16 years of available data.
The Merrill Lynch Option Volatility Estimate (MOVE) Index of bond volatility has also trended higher since the election.
"Equity markets are putting their faith in a batch of new ‘puts’ and not least the ‘Trump put’," Societe Generale economist Michala Marcussen wrote in a note to clients.
"Given the long list of political events to come, however, this picture seems all too smooth."
Investors are right to bet that more lax regulation, lower corporate taxes and a bit of infrastructure spending will be good for corporate profits and equity valuations. What is far less clear, and is clearly signaled by foreign exchange and bond volatility, is exactly how likely those policies are to come into effect and what risks they and other Trump plans imply.
CAN’T BLAME THE FED THIS TIME
One common argument for the long-term decline in equity volatility is that same Fed put, the idea being that equities have become less risky due to the Federal Reserve’s demonstrated willingness to serve as a shock-absorber.
That role may be coming to an end. Trump policies would be inflationary, particularly restraints on trade like a border tax. The Fed’s new hawkishness clearly reflects this, both in its apparent willingness to raise interest rates quickly but also in new and very significant discussion about reducing its $4 trillion in bond holdings.
"My own criteria would be if we think the economy is strong enough that we are going to need to do multiple tightenings…At that time we should be seriously thinking about reducing the balance sheet," Eric Rosengren, president of the Federal Reserve Bank of Boston, told the Financial Times last week.
A Fed which is selling bonds is going to raise bond market volatility, which in turn should make equities, all else being equal, both less attractive and riskier. The European Central Bank may face similar pressure by the end of 2017.
This is before we consider the impact of a border tax on the dollar. A border tax, which makes imports more expensive and favors exports, has been discussed at 25 percent, a level which in theory implies a similarly sized boost to the value of the dollar.
Some of that boost has already happened, but a large increase in the dollar would destabilize global markets, something foreign exchange volatility is pointing towards. China and emerging markets would all be hit hard, with the former potentially electing to float the yuan and many of the latter facing financing crunches and sharp recessions.
None of that is a recipe for quiet equity markets, and the resulting volatility may challenge U.S. valuations even if they are supported by tax cuts, government spending and a foreign profits tax repatriation holiday.
Remember too, the Fed is highly unlikely to play the role of equity market backstop in order to insure investors against the ill-effects of protectionist policy.
The Trump put may in the end be worth the paper on which it is not written.
(The opinions expressed here are those of the author, a columnist for Reuters)