August Market Update

August Market Update

When the economy was in the throes of collapse back in March, the Federal Reserve made a monumental announcement. It was establishing liquidity facilities whereby it would step in and buy securities. Since then, these facilities have expanded to include the purchase of Treasuries, individual corporate bonds, municipal securities, mortgage-backed securities, and even bond ETFs. What’s been the reason behind this buying spree in the bond market?

Earlier in the year when markets were in free fall, liquidity in credit markets dried up, leaving companies and consumers unable to borrow in order to survive the sudden economic downturn brought on by COVID-19. By buying securities, the Fed injected cash into the banking system, thereby enabling the credit markets to properly function again.

This kind of Fed intervention by buying securities in the market isn’t new. We saw similar actions taken by the Fed during the 2008 financial crisis. But the Fed’s response to this year’s crisis has far exceeded the response to the Great Recession, as the following chart illustrates:

 

And the Fed isn’t alone. There has been a global response by foreign central banks. The difference is that central banks of other countries have already gone into territory the Fed has yet to tread, and that is the stock market.

The Bank of Japan has been buying equity ETFs since 2010, now owning more than 5% of Japan’s stock market capitalization according to research by Charles Schwab. The government of China is another buyer of stocks, as well as some central banks in Europe. According to WRAL TechWire, Switzerland’s central bank owned more than $94 billion of stock as of the end of the first quarter with large holdings in Apple, Amazon, and Facebook.

So, why not stocks? If the Fed participated in equity markets, wouldn’t that add some stability and temper volatility? Well, for one thing, technically, it’s not allowed. The 1913 Federal Reserve Act prohibits the Fed from buying corporate assets. Critics of the Fed say that the central bank overstepped its authority this year by buying corporate bonds, to which the Fed has responded it was necessary due to unusual – some might even say dire – circumstances.

Aside from the legality of whether the Fed can outright buy stocks, it would be a slippery slope to go down that road. The Fed would run the risk of incurring staggering market losses, or it could be perceived as directly manipulating markets and influencing corporate managements. So far, the Fed has dismissed the need to even consider going down that path.

What might concern market participants about the Fed’s involvement in the bond markets? Since the Fed’s balance sheet has exploded due to its aggressive response to the economic devastation caused by the pandemic, some worry that this massive expansion will lead to inflation. It’s not surprising that gold has done very well this year as some investors anticipate future inflation since gold often increases in price during periods of rising inflation expectations.

The Fed’s liquidity facilities are due to expire at the end of September, thereby ending the Fed’s buying spree. According to Ned Davis Research, the Fed may choose to extend the programs if it deems necessary, or it may let the programs expire. Whatever action the Fed takes, if it’s unexpected, it could lead to heightened volatility in the fall.

Obviously, markets have reacted strongly to this massive stimulus from the Fed, which is why the FSA portfolios are invested again.

As the summer draws to a close, we continue to wish our clients good health and prosperity.

Mary Ann Drucker
Assistant Portfolio

 

 

Disclosures are available at https://fsainvest.com/disclosures/market-update/.

FSA’s current written Disclosure Brochure and Privacy Notice discussing our current advisory services and fees is also available at https://fsainvest.com/disclosures/ or by calling 301-949-7300.

 

 

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