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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.

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?

Ballast for the common stock portfolio - Bonds, Gold, or the USD?

A common portfolio weighting known amongst many investors is the 60% stocks, 40% bonds portfolio. The general idea being that stocks appreciate in a bull market, while bonds keep their value in a bull market. Therefore, if you were long 40% bonds, you would have somewhat had a ballast for the drop in stock price. As of late, however, we have been associating the words “safe haven” and phrases such as “investors flee to safety” with assets such as Gold and the US Dollar. Have bonds lost its relevance as ballast in a modern investor portfolio?

Does a low-interest-rate environment diminish the ballast effect of bonds?

Recession Fed Funds Rate
2020 – COVID 19 Pandemic (Feb – Present) 0.25%
2008 – Global Financial Crisis (Dec 2007 – June 2009) 0.25%
2001 – Dot com bubble (Mar 2001 – Nov 2001) 2.5%
1990-91 – Savings and Loan crisis (Jul 1990 – March 1991) 6.25%

The current fed funds rate is 0.25% - currently matching the lowest, it has ever been a post-global financial crisis in 2008. Recessions before that, however, had the Federal Reserve cutting rates to nothing as low as it is now or during the Global Financial Crisis. 

In short, pre mid-1990’s was where the strong negative correlation between stock and bond returns became evident. This was on the basis that accommodative monetary policy would bring interest rates lower, increasing the opportunity cost in owning bonds as opposed to leaving cash in a savings account. However, if you look at the table above, both in 1991 and 2001, interest rates were high enough for a real yield if you held government treasuries. But in our current environment and 2008? Real yielding safe government treasuries could not be achieved. Therefore, the opportunity cost does not spark as much interest in investors as they did back pre 2000’s, where high single-digit and even double-digit interest rates were present. 

Is having Gold as a Ballast currently paying off?

Performance of the US 10 Year in blue, SP500 in red, Gold in orange and the US Dollar in Teal

As shown by the chart, Gold has returned around 12% year to date, while treasuries have only returned 8%. You can see the markets working in reaction to economic events such as treasuries rising in March as the FED cuts rates and the real damage of the coronavirus pandemic becomes clearer. Furthermore, the inverse correlation between the USD and the price of Gold is present in the chart, with the exception being around mid to late March – where quantitative easing and fiscal spending give rise to concerns to the devaluation of the dollar. As we look into April and May, it is clear that Gold is currently outperforming treasuries, which would be more beneficial as ballast in comparison to Bonds in these circumstances. However, both are outperforming the US Dollar.

Is Gold a better ballast than Bonds in these low-interest-rate environments?

There is a likelihood that Gold will outperform Treasuries in this low-interest-rate environment. Given fiscal and quantitative easing alongside the demand for other currencies slowly increasing, it is likely we see the USD lower at the end of the year than at the start of the year. If the historical negative correlation between Gold and the USD rings true, there is also a high chance that Gold will end up higher at the end of the year.

Interest rates can only go so low. If the Federal Reserve lowers rates into negative territory, New debt issuance by the US Government will be hovering at nominal yields near 0% - with real yields most definitely being in the negative territory. This gives an implicit ceiling as to how high bond appreciation can go. Given a possibility for a second wave, risky assets may still be off the table for many investors. With Bonds providing next to 0% yields, investors may seek to look towards Gold as a source of capital growth instead of yield.

Our analysts here at BlackBull Markets, Philip and Anish,  have some excellent technical analysis on the future of Gold and the USD as the safe havens of the world. You can watch the Philips' Gold analysis here, and Anish's analysis here.