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From Hedge Funds to Fed Puts

In the annals of financial history, the tumultuous rise and fall of Long-Term Capital Management (LTCM) stand as a critical juncture that would set the stage for crises to come, long before Silicon Valley Bank, Lehman Brothers, or the housing market meltdown.

LTCM, boasting a stellar roster of financial luminaries, including Nobel laureates, believed they had crafted a virtually risk-free bundle. Entrusted with tens of billions from banks, their strategy’s failure prompted an unprecedented rescue mission coordinated by Federal Reserve officials. Interest rates were slashed to stem the hemorrhaging stock market. Twenty-five years on, the reverberations of this crisis still echo, giving birth to what we now know as the “Fed Put.”

The concept was simple: by reducing rates in response to stock market declines, the Fed effectively bestowed investors with a safeguard akin to a put option—a risk management tool. Moreover, the Fed’s reluctance to swiftly hike rates again, despite stock market surges, created an illusion of rising prices, coaxing investors into taking on more risks than they’d otherwise bear.

Subsequent events, such as rate cuts following the dot-com bubble burst and massive liquidity infusions after the 2008 financial crisis, followed suit. Today, the Fed might finally be steering markets away from the “Fed-put” mindset, albeit after a quarter-century of influence.

The initial rate cut in 1998, on September 29, came just six days after a $3.5 billion bailout for LTCM, orchestrated by a consortium of financial firms led by the Federal Reserve Bank of New York. At the time, economic indicators indicated a robust job market, with Americans’ income and spending on a rapid upswing. However, stocks had taken a beating. By August’s end, the S&P 500 had plummeted 19% from its mid-July peak, and even though Fed Chairman Alan Greenspan’s soothing words had somewhat calmed the markets, it remained down 12%.

The central bank perceived this as a significant concern, not because stocks predicted economic trouble, but due to the potential economic fallout from the sell-off. Internal Fed documents showed that the stock market boom had significantly boosted annual consumer spending in 1997 and 1998. The fear was, what if this effect reversed?

Market woes persisted, with the S&P 500 revisiting its August lows in early October. The Fed took further action by raising its target rate by a quarter point after an emergency meeting on October 15, only to cut it again on November 17. By November 23, the S&P 500 had surged past its July high. When, on June 30 of the following year, the Fed finally shifted course and raised its target rate by a quarter point, the index stood 13% above its previous high.

As the early 2000s rolled in, stock valuations continued to rise, particularly in the tech sector. Former Merrill Lynch derivatives strategist Steve Kim and former Pimco fund manager Paul McCully coined the term “Greenspan Put.” Their argument was that the expectation of Greenspan riding to the Fed’s rescue encouraged investors to embrace more risk. The dot-com bubble eventually burst, but the idea of the “Fed put” persisted and was vindicated when economists Anna Cieslak and Annette Vissing-Jorgensen found that stock returns strongly predicted changes in the Fed’s interest rate target.

While the Fed will always keep an eye on the stock market, its fear of stock market declines harming the economy has waned. The recent 25% drop in the S&P 500 from its January peak to its October low didn’t raise recession alarms. The Fed’s new financial conditions index gives less weight to stocks than similar measures from Goldman Sachs and others, focusing on the broader economic impact of mortgage rates, the dollar, and more.

The message here is clear: investors banking on market selloffs triggering rapid Fed interventions may find that the safety net they once relied upon has evolved.

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