The US Federal Reserve goes on a shopping spree

The corona-crash on the equity markets and the corona-recession ravaging the world economy are unprecedented events in terms of their speed and magnitude. The response by central banks, led by the Fed, is also unprecedented. This year alone, the total assets on the US central bank’s balance sheet look set to double. The enormous injections of money have repercussions because they lead to distorted valuations and price signals particularly in the area of bonds, which practically drop out of the picture in the future as performance drivers and diversifiers. Stocks have benefited immensely of late from the monetary policy stimulus. Hedging strategies are regaining allure in the wake of the recent rally.


Everything but stocks

While infection curves in the industrialized nations have been gradually plateauing in recent days, economic growth and business and consumer sentiment curves have been pointing sharply downward. The International Monetary Fund (IMF), for example, slashed its 2020 world GDP growth forecast this week. In its baseline scenario, world economic output is now projected to contract by 3%. You don’t need a crystal ball to foresee the macro data trend in the weeks ahead – the numbers look destined to come in weak for the time being. The same goes for the first-quarter corporate reporting season that has just gotten underway. Most business leaders will probably express very cautious outlooks for the months ahead since hardly anyone can make reliable predictions in the midst of the corona-fog.


The sky’s the limit
The Fed’s total assets could double this year

Total assets on US Federal Reserve’s balance sheet, in USD trillion


The US Federal Reserve in recent weeks has done its part to soothe the uncertainty plaguing market participants and economic actors. On March 15, the Fed lowered its policy rate to close to 0% and announced a program to purchase USD 700 billion worth of government bonds. Just a short week later, the size of the new quantitative easing program was ratcheted up to “unlimited”. Investment-grade corporate bonds and mortgage-backed securities have been added to the Fed’s shopping list since then, and last week they were joined by sub-investment-grade corporate junk bonds and corresponding high-yield bond index ETFs. This means that almost every segment of the US bond market is now being supplied with liquidity. Directly buying stocks is the only thing that the Fed is still refraining from. The total assets on the US central bank’s books have swelled from USD 4.3 trillion to USD 6.4 trillion in the span of just four weeks. At this rate, the Fed’s unlimited buying of securities looks set to double the total assets on its balance sheet by year-end.


Quickly cured
Money injection swiftly revives US corporate bond prices

Investment-grade and high-yield bond ETFs



The therapy thus far has produced the desired effect, but also causes certain side effects. For example, LQD, the largest US ETF for investment-grade bonds, has already recouped almost its entire drawdown since the start of March. In the span of just one month, the exchange-traded fund’s trading volume has practically doubled. Given the torrid demand, investors lately have even had to pay substantial premiums to acquire shares in the ETF. The situation for high-yield bonds has also already eased considerably, as evidenced by the much tighter credit spreads. The liquidity injection by the Fed is unquestionably a blessing for investors’ frayed nerves, but it is also clear that the pursued monetary policy is to some extent distorting the price signals from corporate bonds, which used to be a reliable indicator of economic activity in past times.

Ballast in the portfolio?

The Fed’s shopping spree also has an unmistakable impact on market interest rates. The yield on 10-year US Treasury notes has been fluctuating in a narrow range between 0.6% and 0.9% since the announcement of unlimited QE. Although its securities purchases are soon likely to be dialed back a bit, the Fed nonetheless remains a constant source of demand for US Treasurys for the time being. We therefore do not expect to see a sustained climb in US long-term yields above a 1%–1.2% level for quite some time yet. Meanwhile, the potential for lower yields and attendant further price gains is tightly constrained.


No more yield in the end
Thirty-year bond bull market draws to a close

10-year yields on US government bonds


With QE4ever, the 30-year downtrend in yields looks likely to have come to an end at the zero line. Inversely, in the wake of continual gains over three decades, bond prices now are pretty much stretched as far as they can go. These days, further price gains on further declining yields are hardly possible any longer, and on top of that, interest coupons are very low. Whoever buys a 10-year US Treasury note today faces a high probability of having to accept wealth erosion and a loss of purchasing power at the end of the term. Investment-grade bonds thus drop out of the picture as a return driver for the years ahead. Moreover, they will have only a limited ability to exert their usual stabilizing effect on a balanced portfolio in the future. Ultralow interest rates have further reduced bonds’ attractiveness relative to stocks.


Stocks are attractive in relative terms…
…but are not a bargain in absolute terms.

Equity risk premium



Navigating through the corona-fog

But the monetary-policy response to the public health crisis exerts visible effects on the equity markets that go beyond valuation issues. In the span of just three weeks, the S&P 500 index in the USA has already clawed back more than half of its drawdown since mid-February. As was the case during the last three episodes of quantitative easing, the latest version – QE4ever – has likewise put a tailwind behind stocks. Viewed with some detachment, the recent rebound isn’t abnormal (thus far), but is merely proportional to the preceding crash. What would be abnormal is if, despite support from monetary and fiscal policy, the rally were to continue in the weeks ahead without any temporary setbacks. The uncertainty about economic activity and earnings going forward is too high for such a scenario. Our baseline expectation thus tends more to foresee a renewed pullback in stock prices that will correct the upmove since late March by at least 50%. That point will be where the market decides whether there will actually be a retest of the March market bottom, which more and more analysts have crossed off their agendas in recent days.

Against this backdrop, it appears opportune to give some thought at this juncture to hedging an investor portfolio. The recent decrease in implied volatilities now makes the cost of hedging with options a bit cheaper again than before. Since there is renewed potential for share-price dips in the wake of the recent rally, (partial) hedging of a portfolio makes sense, provided that one chooses the right options strategy.


Oliver Hackel, CFA Senior Investment Strategist

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