Since the lows on March 23, the SPX is up 36%, marking one of the sharpest rallies over the past 100 years. In our previous blog post, “The Money Printer Goes Brrrr And The Bull Case Grows Stronger,” we explained that the backdrop for a risk rally stemmed from aggressive stimulus by the Federal Reserve, broad fiscal spending measures to help employers and workers, and the assumption that the COVID situation would improve as time passed. After the large SPX rally, the weight of the evidence suggests the bull case prevails. The Fed press conference last Wednesday was a critical data point where Jerome Powell clearly stated that the Fed will continue its QE program, and is even inclined to increase it to support liquidity. Some economic “green shoots” have started to appear (such as the May jobs report), though the economic and fundamental situation remains dire. The sluggish economic recovery means the Fed won’t unwind its QE program in the foreseeable future, which is bullish for risk assets. Additionally, the Fed’s pledge to maintain indefinite QE could represent a major turning point for the US Dollar, causing it to reverse its 10-year uptrend. This would have broad implications for commodities, currencies and equities.
The Most Dovish Fed Press Conference Imaginable
Heading into the press conference, there was a justified concern that the FED would taper its QE program given the rally in risk assets, the partial reopening of the economy, and the rebound in some economic indicators. Jerome Powell rejected that concern and was clear in his message that the Fed is nowhere near tapering QE. If anything, the Fed is biased to provide more stimulus not less. Below are the most important excerpts (full video and full transcript).
When asked why not lower stimulus because some economic data is rebounding:
And I’ll — I’ll just say again that we are — the — the May employment report, of course, was a — was a welcome surprise, very pleased. We hope we get many more like it, but I think we have to be honest, it’s a — it’s a long road, it’s – – it’s — depending on how you count it, well more than 20 million people displaced in the labor market, it’s going to take some time, and we are going to be deploying our tools — all of our tools to their full extent in pursuit of that — of those goals, however long it takes.
When asked what if the data surprises to the upside in the near term:
So, I would say, you know, we’d be looking to get inflation back up and we — we’d be prepared to tolerate pretty low — welcome, in fact, not tolerate, but welcome very low readings on — on unemployment, just based on what we — what we saw in the — in the last expansion. So, again, we’re — we’re not thinking about raising rates. We’re not even thinking about, thinking about raising rates. So, what we’re thinking about is — is providing support for this economy. We do think this is going to take some time.
When asked why continue to buy Treasury Bonds if the markets are functioning normally:
And in addition, as I pointed out in my — in my statement, those purchases are clearly also supporting highly accommodative — or accommodative financial conditions, and that’s — that’s a good thing, so that’s why we’re doing that.
The most interesting question came from Michael McKee of Bloomberg about asset bubbles:
I’m wondering, given the levels of the market right now, whether you or your colleagues feel there is a possible bubble blowing that could pop and setback the recovery significantly, or that we might see capital misallocation that will leave us worse off when this is over?
To which Chairman Powell responded (emphasis added):
What we’ve targeted is broader financial conditions….So, what our tools were — were put to work to do was to restore the markets to function. And I think, you know, some of that has really happened, as I — as I mentioned in my opening remarks, and that’s a good thing. So, we — we’re not looking to achieve a particular level of any asset price.….I think our — our principal focus though is on the — on the state of the economy and on the labor market and on inflation. Now inflation, of course, is — is low, and we think it’s very likely to remain low for some time below our target. So, really, it’s about getting the labor market back and getting it in shape, that’s — that’s been our major focus. And I would say — you know, we — if we were to hold back because — we would never do this, but the idea that, just the concept that we would hold back because we think asset prices are too high, others may not think so, but we just decided that that’s the case, what would happen to those people? You know, what would happen to the people that we’re actually, legally supposed to be serving? We’re supposed to be pursuing maximum employment and stable prices, and that’s what we’re pursuing…So, I would say that we’re tightly focused on our real economy goals. And — and again, not — we’re not — we’re not focused on moving asset prices in a particular direction at all. It’s just, we want markets to be working and I think partly as a result of what we’ve done, they are working and — you know, we hope that continues.
In summary, the Fed believes the downside economic risks vastly outweigh the risks of too much monetary stimulus, it is not ready to consider any sort of tapering in the foreseeable future, it’s waiting for the labor market to recover fully before reducing stimulus, and it is not factoring asset prices in its QE decisions.
The Fed is executing on its mandate of maintaining price stability (low inflation) and full employment using the tools at its disposal, which are interest rates and QE. These tools may be sub-optimal to directly impact their mandate, but they are the only tools available to the Fed. According to Powell, the Fed will monitor economic conditions and is inclined to increase QE, which is bullish for risk assets and bearish for the US Dollar (more on that below).
The Market’s Sell-off After The Fed Meeting
The dovish Fed meeting and press conference were followed the next day by a 6% SPX decline, the largest since March 6. Though it’s difficult to pinpoint what caused the market to sell-off, it’s unlikely related to the Fed. In fact, after the afternoon press conference, SPX rallied into the close. A more plausible explanation for the sell-off is the recent spike in COVID cases in several states and in China which brings worries of a “second wave.”
Google trend of “Second Wave” has increased as COVID cases spiked last week
Though worrying, these spikes will hopefully be contained given widespread testing availability and emphasis on maintaining social distancing in public places. It’s also unlikely the economy will be shut down again. More is known about how COVID spreads now than in March, and completely shutting down the economy will likely be avoided by state governors. However, if COVID cases continue to spike and we’re unable to slow widespread transmission, this would undoubtedly put further pressure on markets.
The S&P 500 declined by 6% last Thursday, the largest decline since March. The next support level is around 2920.
A Major Turning Point For The US Dollar
The Fed’s commitment to prolonged use of QE may represent a major turning point for the US Dollar. Over the past 30 years, the US Dollar has formed three distinct tops in 1985, 2000 and potentially in 2020. The current level of 97 is sitting on medium-trend uptrend support since 2010. A break below this trend line would confirm a major decline for the USD with implications across asset classes.
The US Dollar (DXY) is sitting on medium-term support. A break below would likely be the start of a downtrend.
The exact composition of the DXY Index is a weighted basket against the Euro (57.6%), Yen (13.6%), Pound (11.9%), Canadian Dollar (9.1%), Swedish Krona (4.2%) and Swish Franc (3.6%). Outside of this basket, the biggest fx gainers will likely be commodity-exposed currencies like Australian Dollar (AUD), Canadain Dollar (CAD), Mexican Peso (MXD), and Norwegian Krona (NOK).
Another effect of lower USD is higher commodity prices, with the highest impact likely in metals, precious metals, and oil. Commodity prices have declined since 2009 as the USD strengthened.
Commodities have underperformed for 10 years as the US Dollar rallied
Among S&P 500 sectors, a weaker USD suggests future outperformance of Technology, Materials, Energy, and Industrials given the exposure of these sectors to commodities or international markets.
On a geographical basis, Emerging Markets (EEM) will likely outperform the US after 10 years of underperformance. The best-positioned countries are those with commodity exposure including Mexico (EWW), Brazil (EWZ) and Russia (RSX). Another ETF that stands to benefit is the Emerging Markets Internet ETF (EMQQ).
Emerging Markets (EEM) has underperformed for 10 years on the back of US Dollar strength
Lastly, Bitcoin is setting up to have a significant move higher, and a weaker USD would be a strong tailwind. As our friend JC Parets pointed out in a recent blog post, Bitcoin has consolidated over the past 2 years and is primed to make a big move higher.
USD weakness may be a catalyst for Bitcoin breaking out to new highs
The events of 2020 will have a lasting effect on every aspect of our society. On the investment side, the shift in the Fed’s policy to QE infinity will continue to support liquidity and asset prices. The collateral damage is a weaker USD, which will have broad investing implications across asset classes.
The analysis in this blog post was done using Koyfin which offers financial data and analytics to research stocks and understand market trends. Create a free account on our website. Koyfin users are emailed new blog posts as they are published.