The Fed Put Has Become The Fed Collar

Summary

• The Federal Reserve Put is a well-known phenomenon where falling equity prices convert hawks into doves.
• The recent language has been decisively hawkish despite falling stock prices.
• We tell you why the Fed Put strike is now far lower and growth stocks will go through another round of repricing in 2022.
• I do much more than just articles at Conservative Income Portfolio: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »

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2021 was all about disregarding the warnings.

No profits? No problem.

20X sales? No problem.

No Sales? No problem.

After all, it was not hard to find at least one analyst that would forecast huge earnings a decade from now when you would make great money on your investment. To a large extent, the Federal Reserve enabled this. It was their job to tighten monetary policy when fiscal policy was dialed up to a proverbial "10". Instead, under the pretext of waiting till they saw clear signs of recovery, they created the most massive bubble in growth stocks that we have ever seen. Unfortunately, as we forecasted in our 2022 outlook (The Bubble Ain't Coming Back), that was not destined to last.

But falling stock prices have brought forward the question again. When does the Federal Reserve step in to protect risk assets? We explore that below.

Where Things Stand

It is our opinion that if the Federal Reserve was gifted with the James Webb Space Telescope, there is a low chance that they could actually spot the curve. We continue to find the idea laughable that they have been too hawkish. One easy way to demonstrate this is to show what a responsible central bank actually does when faced with inflation.

Brazil Vs US (Bloomberg)

Currently, the markets are pricing in 7-8 hikes in 2022 and we think that is unfortunately too low to restrict inflation. The key reason is that Atlanta Fed's wage tracker is now hitting an all-time high. The recent number came in at 5.8%. Keep in mind that we have had 8% CPI even when wage growth was far lower. For all of 2021, we saw bond and equity bulls argue that interest rates would only go lower. This was based on two factors.

1) The first came from investors taking cues from a broken bond market. The thinking was "current bond yields are low and bonds are always right, so inflation is not a threat". We told you how dangerous that thinking was back in 2021. Obviously losing 21 years of interest equivalent on an 8-year bond in 15 months has shown how wrong it is to rely on bond yields as a prognosticator of anything relevant.

Data by YCharts

2) The second factor came from inflation break-evens. These numbers compute in essence what is the expected inflation over the next 5 or 10 years (depending on which one you are looking at). One comforting factor through all the inflation upheaval in 2021 was that the inflation break-evens were well behaved. They continued to be wrong, but they were well behaved. They forecasted low inflation over the next 5-10 years. This was a great crutch for a broken theory. That crutch also broke in 2022 as break-evens have now exploded to 3.65%.

5-Year Inflation Break- Evens (Bloomberg)

The Fed Put Becomes The Fed Collar

For those that are not familiar with this jargon, let us explain. A collar is an options strategy that involves buying a downside put and selling an upside call. This is implemented to protect against large losses, but that also limits large upside gains. We believe this is where the Federal Reserve is at. Any equity rise and the Federal Reserve will be front and center dialing up its hawkish plans. That is why Powell sounded so aggressive on a 50 basis points hike for May. The rebound in the markets means it is a green light to throw whatever they can to quench the inflation inferno. If we rally another 200 S&P 500 points don't be surprised if May becomes a 75 basis point hike meeting. That is the "call" that is being sold.

On the downside, the Fed will definitely become more dovish if risk assets tank, but that is far away. Assets need to crack enough to bring real (inflation adjusted) retail sales back in line with the trend to control inflation. That won't happen soon.

Real Retail Sales ((FRED))

At present we see the Federal Reserve Put closer to 3,800 and the Calls are anywhere above 4,200 on the SPX. That means hawkish until things really break. Growth stocks look most vulnerable for another large drawdown in the months ahead. All of this volatility though is excellent for cash-secured puts and covered calls. The high premiums enable us to enter value stocks with a large amount of buffer and generate better risk-adjusted income. 2022 has already been excellent in that regard and we think it will continue to deliver.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.