The Fed’s Alchemy is Turning Just Right Bad News into Good News

There must be some kind of way outta here,
Said the joker to the thief.
There’s too much confusion,
I can’t get no relief.

–Bob Dylan (though best performed by Jimi Hendrix)

While these famous words from the song “All Along the Watchtower” were recorded all the way back in 1967, they seem very fitting for the situation we find ourselves in today, over 53 years later.

But it’s not necessarily relief from the worst pandemic in over 100 years that traders and investors are necessarily looking for right now (though it would certainly be welcome). Instead, it is relief from another source that would continue to push the market higher.

From the market’s perspective, the “way outta here” is through the Federal Reserve.

Here’s what I mean…

Stop Me if You’ve Heard This Before

Broken record alert: Coronavirus cases are spiking across the South, West, and Midwest.

Apple Inc. (AAPL) is closing U.S. stores again, as it did earlier this year as the COVID Crash hit.

Hospitals in Arizona and Houston are out of beds.

Florida reported more new cases on Sunday than any state ever has, including New York.

Meanwhile, the Nasdaq Composite index is hitting all-time highs almost every day – even yesterday (Monday 7/14), when the index hit another intraday high before the big afternoon reversal. Inc. (AMZN) climbed an amazing 20% in just ten days (again before yesterday’s afternoon pullback).

And it’s not only tech that’s rallying. The S&P, Dow, and Russell 2000 indexes have also recovered most of their losses.

Big Media will say markets are rallying despite the bad COVID-19 data, and that the markets and the economy are disconnected and leave it at that.

Wall Street will tell you whatever they think will make you buy, buy, buy. They want their commission and fees to keep flowing.

The real truth is that markets are rallying because of an amazing feat of “financial alchemy.”

It’s a feat that’s worked since late March, and will keep working for a while.

But that doesn’t make stocks bullet-proof.

Far from it…

The Impact of a Massive Fed War Chest

It’s probably no surprise that part of the story is the Federal Reserve. As you can see in the chart below, the Fed’s balance sheet has grown at record speeds, from an already enormous $4.2 trillion to more than $7 trillion:

The goal has been to prop up the U.S. economy and the global financial system amid the COVID-19 pandemic and subsequent lockdowns.

But during the unprecedented crisis, the Fed has also taken unprecedented measures.

Much of this stimulus money has been spent on the same sort of quantitative easing (QE) we saw after the 2008 Financial Crisis. That involves mostly buying U.S. Treasury bonds and mortgage-backed securities, with the effect of pushing down bond yields, interest rates, and mortgage rates.

Unlike in 2008, this time around the Fed has also said it will buy corporate bonds and even bond ETFs. It has already been doing both.

The theory behind these moves is simple:

Lower bond yields make it easier for companies to issue more debt, which will help keep them afloat.

Lower interest rates make it more rational for people to spend their money than to save it, which gets the economy going.

Lower mortgage rates make more people buy houses, which gets the important construction and housing industries moving.

In practice, there are plenty of secondary consequences. One of the biggest is the stock market rally.

The people who still have money won’t put it in their bank account, because interest rates are too low. Many types of REITs and other housing investments are a no-go too, with mortgage rates this low.

Don’t even think about putting that money in bonds hoping for income, as the trifling yields there won’t even cover inflation.

And with travel restricted, museums closed, restaurants and bars shuttered or at low capacity, and in general not much to do, there’s few “luxuries” available to spend money on.

So the excess, “unused” money all ends up finding its way to the stock market.

We talked about this in detail last week.

The result has been the fastest stock market rally in American history.

But even this $3 trillion worth of unprecedented Fed stimulus, and trillions more from Congress and the White House, can’t create a rally that will go on forever.

While this one still has some legs left, we’re already starting to see some cracks.

Cracks caused by another unintended consequence of the Fed’s $3 trillion stimulus…

Good Signs are Bad News for this Market

Big Media, both in its regular and business-oriented varieties, have long been harping about the “disconnect.”

This is the idea that COVID-19 surging and economic recovery being slow should be sending stocks down. Because stock markets are instead rallying, this means they must be “disconnected” from the economy.

And it’s true that COVID-19 cases are spiking, and that the economic recovery is slow and sputtering.

Yet all that news keeps sending markets higher, not lower.

What may look like a “disconnect” is actually another unintended consequence of all those trillions of dollars being pumped into the markets.

At this point, the rally has gone on long enough that making sense of these stock prices without Fed stimulus would be a difficult task.

That’s perfectly fine. Realistically, the Fed will not be raising interest rates or ending its QE any time this year, and probably not next year either.

But with so many fingers in so many pies, there are many small adjustments the Fed can make to its stimulus program. Each change can affect some small part of the market in very significant ways, without ending the stimulus program as a whole.

That possibility is making investors and traders even more sensitive to what Fed Chairman Jerome Powell and other Fed officials say or do than usual.

For example, last Wednesday the executive vice president of the New York Fed and head of the NY Fed’s Markets Groups, Daleep Singh, said that the bank was slowing down its purchases of corporate bonds, because that market had recovered after $8 billion worth of Fed purchases.

Potentially, the Fed official said, these purchases could stop completely, if the corporate bond market continues to improve.

That may sound like a good sign, but instead markets took a quick nose-dive before recovering.

And yesterday, Dallas Fed President Robert Kaplan said emergency lending facilities launched by the central bank were necessary to support market function, “but they won’t be left in place indefinitely”. And the market did a 600-point reversal.

As you can see, traders are jittery about the Fed. They overreact negatively to any notion that Fed stimulus might end, even though the Fed says it would restart its programs quickly if they became necessary again.

On the other hand, news like Sunday’s record-high increase in COVID-19 cases in Florida would seem to be bad news.

So did last week’s news that the service sector is recovering slightly slower than expected.

Instead, it sent markets higher. Just like with the inverted response to the New York Fed’s announcement, this apparent paradox comes down to the Fed’s stimulus.

After all, the Fed stimulus is meant to support the economy from the ravages of COVID-19. So if COVID-19 gets worse or the recovery is slow, that means the Fed will continue its stimulus programs.

It may even extend or enlarge them. In a largely Fed-driven market, that’s bullish.

It’s a pretty amazing feat of “financial alchemy” that Powell has pulled off.

Of course, his alchemical powers are not strong enough to turn any bad news into good news…

Companies with Foreign Exposure are “Just Right” for Profits

New, unexpectedly bad COVID-19 news would still send markets down. They keep going up only as long as the bad news is just bad enough to keep the Fed stimulating the economy, but not bad enough to scare away investors.

As long as the bad news stays in this “Goldilocks Zone” of bad-but-not-bad-enough, Powell’s alchemy will continue to push markets up.

And with better treatments for COVID-19 than before and a slightly younger population being infected, things are not yet as bad as Big Media is saying they’ll get. We can still avoid the worst outcomes if we act now.

Another set of lockdowns is far from inevitable. As long as the COVID-19 news stays this way – bad enough for Big Media to hype it and for the Fed to stimulate the economy because of it, but not bad enough to spook investors – markets will keep rallying.

There’s also hope that U.S. exports may start recovering soon, now that East Asia and Europe are opening back up and recovering. That would be a good sign for U.S. export stocks that don’t depend solely on what’s happening here.

Together, what this means is that it’s not time to fight the Fed. In the short to medium term, keep an eye on what it’s doing, because right now it’s largely calling the shots.

And this dynamic is especially good for these two export heavy stocks.

Nike (NKE) gets 41% of their revenue internationally and is very China-heavy in that percentage. It has been holding firm above the 50 and 200-day moving averages and is due for a new breakout from its current volatility squeeze:

Apple (AAPL) made a whopping 60% of its 2019 Q4 revenues outside the U.S. The stock has been on a tear and as Asian and European markets reopen ahead of those in the U.S., this is a stock to keep buying on every pullback.

Great trading, stay safe out there, and God bless you,

D. R.

Notify of

View this page online: