The Investment Scientist

Don’t Fight The Fed!

Posted on: August 6, 2020

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There are three major factors that drive the stock market: economic fundamentals, investor sentiment and the Fed. Lately the Fed’s role has become more and more prominent. It’s thus very important to be able to read Fed’s moves correctly. For instance, what does it mean when The Wall Street Journal reports “Fed Weighs Abandoning Pre-Emptive Moves to Curb Inflation.”

Let me show you how I read the Fed’s moves since the onset of the Pandemic …

On March 13th, as the Pandemic was picking up in the US, the Fed announced a $1.5T injection into the market. This prompted my newsletter article  “What Fed’s $1.5T Injection Means For The Market” when I wrote:

There are only three buckets into which this money “water” can go: 1) goods, 2) services and 3) assets. Do you think that over the next few months, we the people will consume more goods and services? Apparently not since we will all be hunkering down in our basements. The only place the new money can go is to purchase assets, meaning stocks, bonds, and real estate.

The Fed’s announcement fell on deaf ears since everybody was busy throwing away the baby with the bath water. So the Fed upped the ante on March 24th by announcing “unlimited” asset purchases. My newsletter article about this was titled “Fed’s Unlimited Asset Purchases: What That Means For You and Me” and here I quote:

This unlimited liquidity could spill over to the equity market and cause a rally once the fear that has been gripping the market loosens. With this much liquidity, an equity market rally is almost certain with or without a recovery of the economy.

In June, when the Fed announced that it was buying $250 billion of corporate bonds, this was new since in the past, the Fed only bought treasury bonds and mortgage-backed securities that had implicit guarantees from the federal government. This is what I wrote:

The news that the Fed is buying $250 billion worth of corporate bonds, first and foremost is that the Fed is creating $250 billion worth of new money.

So how should we read the report that the Fed’s abandoning pre-emptive moves to curb inflation? The way to curb inflation is to “un-print” money, that is to sell assets on the central bank balance sheet to recycle money and essentially destroy it. Historically, the Fed has had a 2% inflation target. That is, if inflation is approaching 2%, it would start to un-print money. The report suggests that the Fed won’t do that going forward. I read that as bullish for all measures of asset, but bearish for the dollar itself. In fact, since my last article titled “The Negative Consequences of Fed’s Monday Creation” when I wrote:

… the Fed is the only central bank that has signaled “unlimited” money creation. Once the market begins to fully digest the implication of this, the dollar will slide. 

the dollar index has gone down nearly 5%.

In the last four months alone, the Fed has made a sequence of rapid-fire decisions that are unprecedented: unlimited asset purchases, direct intervention in the corporate and municipal bond markets, and now abandoning the inflation target. All of these should make investors smile now.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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