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Don’t fight the Fed, or the second wave?

Don’t fight the Fed, or the second wave?

Amid bankrupt stocks like Hertz and Chesapeake rallying, we have signs of rationality coming back into the markets today. The second wave caution that investors and traders have has played excellently in the markets. However, fundamentals have not been forgotten either.

  • Gold is up 1.1% as their role as a safe haven continues
  • NASDAQ is up 1.18% as tech companies with strong balance sheets get some traction. SP500 and the Dow Jones are up around .56 % and .27% respectively.
  • US 10 Year Treasuries slipped 4 points as the Fed pledges to buy corporate bonds
  • Oil is up 2.3% as Saudi affirms smaller producers are committed to cuts

As cases in Beijing and the United States spike, investors are aware of the effects of a second wave on the stock market. And we have seen that play out perfectly today. Safe havens Gold and Bonds are up on Fed buying and investor cautiousness. Stocks are up on investors buying the dip, which they have been taught to do since the Global Financial Crisis. Oil is up on signs that supply-side issues are being resolved. Hertz and Chesapeake - are down. Markets are reacting to new information as they should be – speculation aside. However, the second wave may destroy any optimism the market has in a full recovery – or will it?

Second wave risks bursting market optimism

There is a common saying – Do not fight the Fed. The general idea is that if the Fed is cutting interest, not only does this signal to the market that 100 or so individuals with Ph.D.'s think the American economy is in need for accommodative financial conditions, they provide the conditions to do so by lowering interest rates. Therefore, it would be wise to invest in equities as companies are likely to perform better during this period of low-interest rates.

However, during this Coronavirus pandemic, the Fed has come with a gun with unlimited ammunition – quantitative easing. While interest rates can take time to show fundamental effects in firms' bottom lines, quantitative easing uses the Fed's ability to virtually print money to buy anything it pleases, mainly government and corporate debt. Long story short, the intended result is to pump cash/liquidity into the markets. However, it has the effect of saving lenders from losing money as the Fed takes on the debt risk. Therefore, the spread of the damage would be limited to the stockholders if a company goes bankrupt. This sentiment, where the Fed will most likely prop up markets, has fueled the rally since the start of May.

The Feds balance sheet. Asset purchases have ballooned in comparison to 2008

But a potential second wave will put the Fed's powers to the test. During the initial downturn in mid-April, little was known about the lengths the Fed was willing to go to stabilize the American economy. But now things are much clearer – they will do everything in their power (and in this case, their power is unlimited asset purchases) to save the American economy.

Second wave vs the Fed: Who wins?

This has implicitly put investors on two teams: The second wave, or the Fed. Investors are either betting on the second wave to push investors and traders to sell their positions, outpacing the Fed's buying. Or betting that the Fed's asset purchases will keep asset prices high, even if there is a second wave. Who will win?

This has been front and center on many investors' minds, including mine. Unlike the first wave, we are better prepared for the second wave, with the Fed ready to ramp up purchases at a moment's notice. However, a second wave may finally solidify the threat on earnings the Coronavirus has on companies. As Bill Blain from Shard Capital states – "As the recession bites, and unemployment rises… markets could experience a serious reality check."

Regular investors who want to back the Fed may hedge their risk slightly by keeping some cash on the sidelines, averaging down if prices take a tank. Investors who support the second wave may want to stay fully invested in safe havens such as bonds or Gold.

Which side are you backing?