A Fed Exit Strategy

June 23, 2022 | Kelly Shorer & Paul Maxwell


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"The US Federal Reserve has made it clear that its primary objective is to combat inflation."

The US Federal Reserve has made it clear that its primary objective is to combat inflation.

The Fed has also expressed that it is willing to overlook some of the collateral damage that may come as a result.  This could include employment losses, a dramatic retail spending slowdown, stock market losses, or perhaps even corporate bankruptcies.

However, there are some who think that the traditional “Fed put” of the past 15+ years could be revived. 

The “Fed put” is the notion that the central bank will intervene to mitigate major contagion effects, as it has done fairly reliably ever since the Great Financial Crisis of 2008.  Think “Quantitative Easing” or the early stages of COVID where a sustained market meltdown and slew of corporate insolvencies were averted due to massive central bank and government support mechanisms.

We thought it timely to provide some thoughts on potential conditions (outside of inflation starting to come down) that could push the Fed to exit its rate-hiking path.

For starters, financial markets are pricing in an overnight rate of 3.5% by the end of the year.  This is actually slightly more aggressive than Fed expectations.  If reached, this would bring conditions above the Fed’s estimated ‘neutral rate’ and further moderate economic growth.  This could lead to a triggering of the potential scenarios seen below.

  • Potential Condition #1: The material degradation of the liquidity and functioning of financial markets.  If capital markets are unable to satisfy the needs of US firms, the Fed is unlikely to keep the accelerator pressed to the floor.  As illustrated in the chart below, some cracks are already forming:

  • Potential Condition #2:  Significant widening of credit spreads coupled with a recessionary bear market for equities.  Credit spreads relate to the excess interest rate (vs government bonds) that companies must pay on their debt to obtain financing.  Levels of pessimism in the marketplace are currently high but not yet in line with the extremes seen in previous US recessions.  Another equity market dive or blowout in credit spreads could present the possibility of moderating Fed policy.  Spreads for lower quality high yield issuers have crept up rather meaningfully in 2022 from ~3% to over 5%:

  • Potential Condition #3:  A material weakening of labour market conditions.  The labour market is still said to be tight, but the first signs of layoffs are beginning to arise, particularly in high growth sectors such as tech.  If the unemployment rate rises meaningfully from its current low, the Fed may have to grapple with the “dual mandate” of optimizing inflation and jobs.