Game changer, but only for the short term

  • The Federal Reserve readiness, or willingness, to stop selling bonds if need be, is a game changer, but only with respect to short-term expectations.
  • Given we may have all but reached the end of the monetary tightening cycle, testing the September highs is now a real possibility.
  • While earlier than expected, the Federal Reserve dovish pivot does not warrant a change in investing strategy, at least for the time being.

In our update of last week, we opined that the market was at a cross road and needed a strong dose of good news to continue its rally. The hope was that strong corporate earnings growth would oblige. That has been the case so far, except there was more, much more. Not only the Federal Reserve (The Fed) did not raise interest rates, but the tone of their update was very dovish. Most importantly, the Fed signalled that it might consider halting its bonds sales in the market. This is a major turning point for both stocks and bonds, for several reasons:

First, stopping the sale of bonds means no more liquidity will be drained from investors' hands. This is a major positive for all asset classes. The market reaction was immediate, with major rallies staged by both stocks and bonds.

Second, what the Fed Chairman said when first appointed, namely that Fed policy will not be dictated by market movements, is now in serious doubt. Practically the Fed has all but caved in to market tantrums. The reality is that both investors and politicians have become addicted to quantitative easing. Reversing it is proving to be extremely difficult, certainly much more difficult than ex-Chairman Bernanke suggested, or thought, when he first promoted it. Until further notice, it would appear investors can now count on the Fed to come to the rescue when the market outlook sours. The Fed will never admit that openly, but that is exactly what they did last week.

To put things in perspective, the selling of bonds has not yet stopped. For the time being, the Fed is feeding the market good words. That was enough to prop equities by more than 2% in one day. But action will follow. The next step, when the time comes, would be to announce the actual halting of bond selling. Further steps would be to announce readiness to resume quantitative easing(QE), before launching "QE Round 2". We see all that happening, in the sequence described, as a real possibility.

What we need to do, as investors, is watch the next steps. The base case scenario is that the Fed will indeed stop selling bonds soon. Timing will likely be somewhere before the middle of the year, depending on the extent of the economic slow down and how the market responds to it. Between expectations and reality, the equities rally would likely continue feeding on itself until the market becomes overbought again.

Please note the use of words like possible, likely or probable. When we discuss market outlook, one has to always choose words very carefully, because there is no certainty. Remember that financial news is always a succession of good news and bad news. If tomorrow (or next week, or later) the market fails to break key resistance levels, or if investors start to react aggressively to one or two pieces of bad news, that would likely mean that the rally has fizzled.

Depending on the severity of the economic slowdown, the Fed would likely be forced to start buying bonds again. The US budget deficit is adding some $1 trillion of bonds supply each year. China, where the trade surplus is slowing down, is no longer a heavy buyer of US bonds, and neither are oil exporting countries. Who will absorb the additional supply of bonds? Probably central banks again. That would probably come sometime next year. The only thing that would prevent is a resurging of inflation, which is something to watch very closely. Again, all things considered, it will be a cocktail of good and bad news. This explains why almost everybody is convinced that market volatility will remain with us for the foreseen future.

Does that require any change of investing strategy? Not really. We believe that the five market moves that we proposed at the beginning of the year are still relevant. If you recall, we had expected the Fed to do what it did last week. We just did not expect it to happen that soon. Recall that good (or bad) news often happens when least expected.

One of the five suggestions was to load up on interest sensitive stocks, which would benefit from the prospects of lower interest rates. That turned out to be a very timely suggestion. The other suggestions remain equally valid, and each, we hope, would prove beneficial in the long run. In the meantime, enjoy the ride!

February 5, 2019

Important disclaimer: this article and other articles or content of this website reflect the views of FundScope Limited and /or its contributors and should not be construed as investment advice or recommendations to make specific investment decisions. Neither FundScope nor any of its content contributors will take responsibility for any errors, omissions or misrepresentations, or any responsibility for investment decisions or losses made as a result of reading this artile or using our website. We shall not be liable for any damages, direct or consequential, arising from the use of this website or or any of its content. Investors are strongly advised to conduct their own proper due diligence and use the services of licensed investment advisors before making any investment decisions.