In the annals of financial history, the tumultuous rise and fall of Long-Term Capital Management (LTCM) marks a critical moment that sets the stage for future crises, long before Silicon Valley Bank, Lehman Brothers or the housing market collapse. .
LTCM, which boasts a stellar roster of financial celebrities including Nobel Prize winners, believed they had put together a virtually risk-free bundle. The banks were entrusted with tens of billions and the failure of their strategy led to an unprecedented bailout mission coordinated by Federal Reserve officials. Interest rates were cut to stem the bleeding stock market. Twenty-five years later, the consequences of this crisis are still reverberating, giving rise to what we now know as the “Fed Put.”
The concept was simple: By cutting interest rates in response to stock market declines, the Fed was essentially offering investors a security akin to a put option: a risk management tool. Furthermore, the Fed’s reluctance to quickly raise rates again, despite stock market gains, created the illusion of rising prices, prompting investors to take on more risk than they would otherwise bear.
Subsequent events, such as interest rate cuts after the bursting of the dotcom bubble and massive liquidity injections after the 2008 financial crisis, followed suit. Today, the Fed may finally be weaning markets away from the Fed-put mentality, albeit after a quarter-century of influence.
The first 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 showed a robust labor market, with US incomes and spending rebounding quickly. However, shares had taken a hit. By the end of August, the S&P 500 had tumbled 19% from its mid-July peak, and while Fed Chairman Alan Greenspan’s soothing words had calmed markets somewhat, it remained down 12%.
The central bank saw this as a major concern, not because the stocks portended economic trouble, but because of 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 troubles continued, with the S&P 500 returning to 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, before cutting it again on November 17. By November 23, the S&P 500 had surged past its July high. When the Fed finally reversed course on June 30 of the following year and raised its target rate by a quarter point, the index was 13% above its previous high.
As the early 2000s dawned, stock valuations continued to rise, especially in the technology 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 that Greenspan would come to the Fed’s rescue would encourage investors to take more risk. The Internet bubble eventually burst, but the idea of the “Fed put” persisted and was confirmed 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, fears of stock market declines hurting the economy have diminished. The S&P 500’s recent 25% decline from its January peak to its October trough has not set off any 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 who rely on market selloffs that trigger quick Fed intervention may find that the safety net they once relied on has evolved.