Possible Fed actions if SPX falls 10-12% more in March.
They wont do f*cking QE FFS.
As I write this article the SPX is down 4.8% on the week and pundits are predicting a further sell off of 10-12% followed by an immediate recession and the Fed restarting “QE” in less than 3 months. This article will discuss the potential for the equity correction, if it happens at all, to generate a response by the Fed to restart “QE”. The tl;dr is that there is zero probability that the Fed will start large scale asset purchases in the next three months. Some pundits have also created a cottage industry of things they call “Not QE QE” claiming that these alternative Fed actions have the same impact as large scale asset purchases. The pundits are right to point out the levers that the Fed and even the Treasury has to offset financial stability issues by adding reserves to the banking system or bailing out failing or vulnerable financial institutions and so I will address the probability of “Not QE QE” actions by the Fed but would also add that the odds of those actions are also close to or equal to zero in the next 3 months.
Where are we today? The Fed has Fed funds set at 4.33% and has suggested that they will keep that rate for the March meeting and perhaps longer as the Trump administration rolls out its policy initiatives. The Fed is continuing the opposite of QE called QT by rolling off their existing balance sheet at roughly 45bn per month. If the reconciliation package being negotiated in the Congress is passed the Fed is highly likely to continue QT at that pace for the next 4-10 months. In recent minutes the Fed indicated the potential that a failure to pass a reconciliation bill that lifts the debt ceiling might cause them to pause or slow QT that makes sense but isnt likely to happen based on the current status of the reconciliation bill. All that said for those in the back. Stopping QT in the next 3 months is possible as it is near its goal but Stopping QT is not QE.
Some disclosure about my views and positioning. I expect the Trump Policies to slow growth which will disappoint investors and cause stocks to fall. I am short stocks. However I will almost certainly cover and go long if a 10-12% selloff happens from here. I also have written an extensive script that predicts that killing inflation can only be accomplished by a reduction in asset prices which curbs demand. In the event that Fed is patient and maintains its policy stance and the Trump Administration successfully implements its policies I suspect that a real growth slowdown will occur and the Fed will be able to lower Fed Funds rates in modestly faster than is currently priced. For those reasons I am long SOFR June 2026 Futures which currently price 75bp of cuts over the next 18 months. If I am right I expect the Fed to cut 125bp over that time period to get to a neutral stance in Fed funds.
So lets step back. The equity market is down 4.8% in 6 trading sessions and fell from just under its all time high. The Fed is overjoyed with this outcome. They have no concern whatsoever about that fall. In my view they would be happy if the market corrected another 10-12%. However they would have some concerns. Those concerns would be.
Would the equity selloff create a systemic financial stability issue.
Would the equity selloff create a much more rapid slowdown than desired which would cause the Fed to consider cutting the Fed funds rate faster than planned.
Almost all market participants have lived through the SVB and LDI finacial stability crises. Many have even lived through the GFC. A few of us Graybeards have lived through decades of financial instability episodes which have been idiosyncratic or systemic. All financial stability episodes that become systemic impact the banking system. In order to determine what creates a financial stability crisis its useful to categorize the different versions. They are.
Credit Crisis - a set of sovereigns, corporates, individuals or any other nonbank entities are unable to pay back debt they owe. Even banks themselves may be unable to pay back debt they owe (GFC for example). A credit crisis becomes systemic when losses from bad debt overwhelm the banking system and broad insolvency occurs
Duration Crisis - SVB and a niche in the British Pension Schemes were overwhelmed by market losses on long term bonds and became insolvent or at least illiquid.
Liquidity crisis - In this case otherwise solvent institutions are forced to liquidate because they are unable to borrow to finance their assets. When this happens the financial system can break down and normal market functioning can be interrupted systemically.
So the question at hand is will a 10-12% drop in the SPX in March going to cause a systemic financial instability crisis. Once determining the risk of such a crisis occurring the next step is to determine the likely Fed response.
The problem with all of this analysis is that it deals with a range of known unknowns and known risks. I want to be clear that there are truly unknown risks that we must consider. But also that unknown risks are very very rare. Even what appears to be an unknown risk is usually due to lack of analysis and imagination. For instance Enron appears to have been truly out of the blue. That event simply highlights that fraud is a known risk and was just poorly considered. Anyway with as much imagination as I can muster I’ll consider the risks of a financial instability crisis driven directly by an spx selloff and indirectly with a coincident weakening in the economy.
I think it is clear that a 10-12% selloff in SPX would ripple through the global financial system. Even during the small selloff so far in February short term interest rate markets have rallied 45bp expecting the Fed to cut more than was expected before the move. I imagine losses by leveraged players would be sizeable creating a deleveraging impulse. Of course in order to deleverage others would need to buy the assets being sold which would most likely result in a leveraging up by the buyer. This point is critical. The deleveraging would have a far greater impact if financial leverage was not available to the buyer of the risky assets being sold.
The existing financial leverage markets (swap spreads, futures basis, repo balances) are all priced at very favorable levels for those who have balance sheet to provide financing. Furthermore the reserve balances systemwide are abundant. Lastly the leverage providers (banks in particular) are extremely over capitalized relative to their risk. We add up the financial conditions as very far from concerning. We don’t expect that a liqudity crisis would develop even in a broad deleveraging driven by a global equity drawdown.
It is also highly likely that duration would rally (as it has so far) in an equity drawdown during a coincident economic slowdown. That would improve conditions for the solvency of the banking system.
This leaves credit as the driver of systemic risk. The growth in private credit has been anemic as public credit growth has squeezed out private credit and perhaps more importantly private credit has a much better balance sheet and income to draw on than in any historic credit scenario I have lived through. As always financing needs evolve through time and given the strength of the private credit market I tend to discount the hysteria over a credit wall coming. Private creditors may need to refiance next year but they have known that for many years and have been preparing. The idea of a waterfall of private sector credit demand springing upon us seems doomer porn. Credit markets will likely widen as equity markets sell. But any sort of solvency crisis that becomes systemic would seem to require a much bigger equity move and/or a much much deeper economic slowdown. That sort of slowdown doesnt show up from a modest fall in equities rapidly if at all
So I don’t expect any sort of financial stability problem developing from an equity drawdown. I am negative on economic growth but cant extrapolate that to a rapid fall to negative growth based solely on an equity market selloff. That said I can extrapolate a meaningful slowdown over the course of the year if the Trump Agenda achieves its goals of meaningful doge cuts, the expenditure cuts built into the reconciliation bill, the slowing down of immigration, and institutes sizable tariffs to offset other tax cuts. I think the goal of the administration is to shrink the public sector meaningfully and in so doing will by definition place downward pressure on the economy. But none of that is certain. Nor does it happen all at once and cause a crash like slowdown.
What if I am wrong and a 10-12% SPX selloff in March causes a financial stability issue. What tools does the Fed have to address that outcome. Financial stability concerns often require immediate action by the Fed or other financial system insurance providers. There are two responses that could occur.
The Fed could provide loans to offset illiquidity via programs like SFR or the Discount Window. A special program like BTFP could be revived but seems less likely given the above programs. Of course Large Scale Asset Purchase or QE are available as well. But the primary tool would be lowering the Fed funds rate rapidly to encourage private sector credit growth. Given the condition in the private sector balance sheet which are underweight credit risk and overweight public sector debt we see little need to support financial markets with QE and would expect a financial stability issue given the conditions to be responded too with existing liqudity programs and a somewhat rapid cuts in Fed Funds. If the financial stability crisis was deemed temporary like the LDI crisis a brief buying of assets could occur but seems unlikely to us.
So lets add that up. If the SPX falls 10-12% AND a financial stability issue develops AND the existing programs AND rate cuts of say 200bp fail to stabilize the financial system then asset purchases may be considered. The probability of all those things happening and failing approaches zero in our view. But you never know for sure. Regardless holding short equities and long sofr June 2026 futures will kill it if that event occurs.
We aren’t positioned because we are betting on that unlikely event. We are positioned for an equity market selloff and policy implementation to lead to to an economic slowdown which will kill inflation and allow the Fed to lower short term interest rates over the next 18 months. However, we also think the Fed will continue to finish QT and respond to an economic slowdown as policy becomes more clear and the data indicates a slowdown is underway. They are patient and not panicking.
Not QE QE. As we have said QE is a defined term which is large scale asset purchase. The cottage industry of pundits has coined the term Not QE QE. Let me address what those things are.
Treasury spends their checking account
Treasury and Fed bails out financial institutions with deals to save depositors
Fed provides securitized lending to the financial system at a sweet heart deal (BTFP was an example) SFR and DW are not.
Not QE QE does increase bank reserves in the system but doesnt buy assets so doesnt reduce private sector asset holdings. Its a push. Not QE QE also offsets bank failures and forced deleveragings. This reduces private sector risk and is beneficial to asset prices. If these programs are sized and implemented properly they are a post crisis return to normal. However as seen in SVB they can be way to much and shift from crisis deleveraging to animal spirits leveraging up. Our view is that
TGA isnt going to be spent down as the debt limit gets lifted soon.
Financial institutions are unlikely to be stressed by a sell off in equities
There is no takeup of any NOT QE QE programs at the moment and no sign in the reserves market or bank stocks market that such a take up will occur
Hope this helps