Why Traders Should Care About The Federal Reserve in 2020

Why Traders Should Care About The Federal Reserve in 2020

With a temporary shutdown of a large portion of the United States economy and high unemployment, the stock market continues to rise. Things are confusing, and lots of people are blaming the Federal Reserve.

For many, it’s easy to ignore the Fed-related hysteria because those yelling the loudest are the same folks trying to sell you physical precious metals and calling doomsday each time the S&P 500 drops a few percent.

It can be easy to say that a “broken clock is right twice a day” and move on.

Not so fast…

The Fed has taken some actions over the past six months, which will have unquantifiable effects on the global economy, positive and negative.

Among them are:

  • Allowing inflation to “run hot.”
  • Printing trillions of dollars
  • Buying corporate debt

These are pretty unprecedented events.

Before we continue talking about the Fed, though, we should craft the perception of the current stock market that many see today, and how confusing it is.

 Unemployment Dips, Stock Market Rips?

The unemployment rate is one of the key macroeconomic indicators to gauge the health of an economy quickly.

Below is a chart, courtesy of CabotWealth, which shows how strong the negative correlation between stock market returns and the unemployment rate is.

Federal Reserve

The trend is broken, and now the market is making new all-time highs amidst an unprecedented unemployment rate.

GDP Declined 9.5% in Q2 2020?

The second quarter of 2020 saw the largest single-quarter decline in GDP growth in US history, contracting 9.5% in the second quarter of 2020, compared to the same period in 2019.

There’s a misconception spreading right now that GDP actually declined 37% in Q2, but this is a misunderstanding of the data. The 31% is annualized, which assumes a similar contraction trajectory to continue for Q3 and Q4.

This is a ridiculous assumption, given that the US economy was almost completely locked down for a significant portion of Q2.

Here’s a chart showing the severity of Q2’s contraction:

Federal Reserve 1

Throughout modern US history, the growth rate of corporate earnings and the stock market has been heavily correlated to GDP growth. Based on the short-term price action following the coronavirus lockdowns, that correlation looks to have been broken.

First, here’s a chart from MSCI Barra comparing the growth rates of corporate earnings and US GDP. Based on the chart alone, it shouldn’t come as a surprise that MSCI concludes that these two figures generally move together over the long-term.

Federal Reserve 2

But, like I just said, this correlation is clearly broken, at least in the short-term. We’re left asking which of the following scenarios is most likely?

  • The market is an efficient discounting mechanism and is projecting, correctly or incorrectly, a significant economic “checkmark” recovery in the coming quarters.
  • The correlation has broken, and the relationship between US GDP and stock market returns no longer provides reliable signals.
  • Monetary policy has distorted this relationship in the short-term, making this analysis relatively useless.

Another way to view the relationship between the stock market and GDP is with a ratio that compares the total market capitalization of US-listed companies using the Wilshire 5000 index, to US GDP.

This is a favorite macroeconomic indicator of Warren Buffet, who calls the indicator “probably the best single measure of where valuations stand at any given moment.”

This indicator’s data goes back to the 1970s and provides a pretty useful indicator for spotting broad market tops and bottoms.

Federal Reserve 3

Given both the recent price action in US indices and the significant GDP contraction, the ratio currently exceeds its dot-com bubble highs.

Why Is The Market Going Up?

Given the dire situation I painted with GDP and unemployment numbers, many ask why US indices are consistently making new all-time highs every week?

Shouldn’t the stock market be going down with everyone staying home and the economy still on semi-lockdown and under threat of further lockdown again in the fall?

The common-sense answer to this question is yes.

And common sense might be correct in the end. But common sense ignores the less obvious factors contributing to the current market rally.

The Fed Is Buying Assets

During the global financial crisis, the Federal Reserve introduced quantitative easing. In a nutshell, they bought toxic mortgage assets from failing banks who would have brought down the financial system if no other buyers were present.

They also bought US treasuries to expand the supply of money. So while the Fed isn’t running physical money printers to stimulate economic activity, they’re kind of just adding a step.

This act of QE was seen as a last resort act by the Fed to save the global financial system from completely collapsing.

Some say that the system should have been allowed to fail, but that’s immaterial to the fact that QE worked to save the financial system, if in the short-term.

Fast forward to March 2020. Most of the US economy is shut down, millions are out of work, and many businesses can’t open their doors.

If nothing was done, we would have seen a massive number of bankruptcies and foreclosures, which would have put enormous pressure on the debt markets.

So, the Fed acted again and enacted “unlimited QE” in March 2020. They bought (and are buying) massive numbers of US treasuries to expand the money supply, but they’ve also moved into other areas like mortgages and corporate debt.

As a result, many investors are treating stocks as very low-risk right now, rightly or wrongly. They assume the Fed will prop up the market on any pullback and ensure a smooth stream of high returns.

Interest Rates Are Zero

One of the many actions the Federal Reserve took to avoid a dramatic recession was to cut interest rates to near-zero levels to stimulate the economy.

Let’s think about what this does to markets and the economy. The Federal Funds Rate acts as a top-down interest rate, with which other interest rates move in tandem.

So let’s take a simple example of the individual investor. Imagine you could get a 10% interest rate just by leaving your cash in your local bank.

You would have to expect a significantly higher rate to justify investing in stocks or bonds because your deposit rate is virtually risk-free. In this situation, savers are rewarded.

Now flip that on its head. You get basically zero interest from your local bank, and the presence of inflation virtually guarantees that you’re losing wealth on an annually compounded basis.

It doesn’t take much convincing for you to invest in stocks or bonds. Except, bond rates are also pretty low, leaving you to either watch inflation burn your wealth over the long-term or invest in the stocks.

As a result, investors have “nowhere to hide” and are in effect forced into risk assets like equities.

The Supply of Money Has Expanded Significantly

Inflation is a function of supply of demand. More money in the economy makes goods and services more scarce, in a relative sense.

Imagine this thought experiment. You have a corn farmer and three corn buyers. Each buyer has $100 to bid on the corn they have to buy. The prices paid are a reflection of how scarce both the corn and the dollars are.

Imagine the same situation, but each buyer’s budget is multiplied by 10, so each buyer has $1,000. The same amount of corn is still for sale. The buyers will have to raise their bids as each of their competitors will also be bidding more.

One of the significant effects that the Federal Reserve’s actions are likely to have is increased inflation.

First, let’s consider the broad money supply in the US economy: M2 money supply. M2 is a measure of the available money supply as measured by checking accounts, savings accounts, cash, and near-cash assets (like money market accounts and CDs).

Here’s a chart showing the massive growth in M2 following the Federal Reserve’s post-coronavirus actions. Just to illustrate the rate of relative growth, I added MACD, a technical momentum indicator, to the chart.

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Now let’s take a look at the assets on the Federal Reserve’s balance sheet.

Federal Reserve 5

The Fed balance sheet rose to a high of over $7 trillion following their open market activities in which they’ve bailed out several different troubled industries.

Final Thoughts

I’ve seen even the most ardent bears turn bullish on US equities in the past few months due to the current backdrop. It seems that the Fed will stop at nothing to support the stock market, which is likely to have trickle-down effects on the economy.

The Federal Reserve plays a larger role in stock market price action than ever before, whether in the psychology of market participants or the Fed’s direct buying of assets.

Understanding their activities is crucial to forming a macro thesis for US economic growth and the long-term growth of US equities.

I strongly suggest keeping a tab on their activities through their press releases.
Credit: Warrior Trading

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