Stocks Pause as Fed Punchbowl Springs a Leak

Don’t fight the Fed is a well worn adage that has proven its value once again during the COVID-19 pandemic as record injections of Central Bank (Fed) reserves coincided with a record run higher in our stock market. The Fed began its quantitative easing (QE) experiment when they printed a whopping $3.6 Trillion of imaginary money to provide liquidity to a panicked banking system from 2008 until 2015. Throughout that phase and beyond, the stock market rocketed higher in what would become the longest Bull market in history. Below we can see more recently that the Fed gradually removed reserves from the system in 2018 until August 2019, during which equities moved sideways. By August 2019 a more pronounced economic slowing spurred the Fed to reverse course again and start buying bonds to keep interest rates low and banking standards loose. On cue in Q4 of 2019, stocks zoomed right back to new record highs repeatedly until the pandemic struck Europe and the US in late February triggering an investor panic. After several weeks of economic and stock market collapse in March, the Fed acted with their usual shock and awe adding over $3 Trillion to the banking system in 3 months. This backstopping of the financial system suddenly converted panic selling into buying panic as stocks soared a record 40 to 50% from the late March lows over the ensuing 10 weeks. 

Buying when the Fed is printing money by the Trillions has always been a winning investor strategy. Caution when the Fed is draining their Trillion Dollar punch-bowl is also warranted. Now that our Federal Reserve Bank has accomplished its major goal knocking down credit risk spreads throughout all asset classes with their large bond purchases, they recently removed $250 Billion or about 8% of what they infused. This modest liquidity reduction over the past 4 weeks in contrast to 14 straight weeks of massive stimulus make stocks slightly more vulnerable to correction. With so much liquidity remaining, there is no reason to expect large equity corrections.  After a record 64% run up in the tech heavy Nasdaq stock index since the March lows, a correction would not be a surprise, especially with the Fed being slightly less accommodative. However, corrections may not be as deep as bargain hunters hope for as any sign of new stress in the system during such a fragile economic environment will quickly trigger new monetary and fiscal stimulus to prevent an escalation of fear, boosting stocks. The current economic fear over rising COVID cases and fatalities is causing renewed lock-downs as expected and may be infecting equity prices near term as we warned in last Friday’s newsletter. 

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