The epidemic of a novel coronavirus swept the entire planet and overshadowed almost all other important events in the world of politics, economics and virtually all other news.
Headline after headline brought more and more panic. After some time, the panic spread to global stock exchanges. The global economy has been paralyzed: work in factories stops, people are advised not to leave their homes, production and transportation are reduced. The PRC Purchasing Managers Index (PMI) has completely collapsed to historic lows. It is not surprising that investors began to dump shares. A sharp decline in demand appears to be coming.
World regulators are hurryingly pouring money into the economy. The Federal Reserve also could not resist. The Federal Reserve did not wait for the next scheduled fiscal meeting, scheduled for March 18, and intead immediately called an emergency meeting and reduced the rate by 0.5%.
An emergency meeting is not an ordinary event, the last time the regulator had to take such measures more than 10 years ago was in the midst of the 2008 crisis. However, the Fed was ready to act a bit earlier when American stock indices made the fastest descent in the past decade.
It is worth noting that Fed Chairman Jerome Powell actually did what Donald Trump requested almost every two weeks. Now the United States will be easier to finance its prohibitive budget deficit. Yields on treasury bonds are near historical lows.
The rule worked: buy on the rumors, sell on the facts, and at first the decision of the Federal Reserve System was perceived negatively, but there is another unwritten rule – don’t fight with Fed. Indeed, the decision of the Federal Reserve offers good opportunities for making money.
Good opportunities for making money
Most likely, large players began to form long medium-term positions, while others emptied their portfolios. The main purchases, apparently, were made as early as “black Friday” on February 28, when sales reached their peak. A colossal spike in trading volume appears to indicate this. In addition, $125 billion of pension money entered the US stock market.
At the end of the month, portfolios are rebalance, as fund managers sell some assets and buy others. Do not forget that the value of financial assets is determined by the value of money. Under the conditions of ultra-soft monetary policy, markets have existed for more than 10 years, and have lost some connection with the real situation in the economy. A striking example is the expectations of global economic growth and the dynamics of stock indices in the period 2013-2015. Economists and analysts cited fair factors that pointed to a downturn, but markets continued to grow.
The collapse in late February
This happened for one simple reason – the money was cheap, and the Fed rate at minimum values. The collapse in late February quickly made stocks in the US and other markets attractive. The Federal Reserve sharply reduced the rate by half a percentage point to 1-1.25% per annum – the minimum since 2017, and the shares not only fell significantly in absolute terms, but also look very attractive.
Bonds of the US Treasury Department are considered a risk-free asset. All financial models are built on this. If this rate is too low, financial institutions opt for more risky assets, in particular stocks: either because of dividend yield, which is higher for them, or because of expectations of growth in value. In both cases, money is transferred from bonds to stocks, since the risk-free premium is too low. Now, 10-year Treasury yields have fallen below 1%. Given the drop in value, the dividend yield on individual shares is now quite high.
The Federal Reserve is pushing bidders to make purchases
Large investors work in the market to earn money and are unlikely to be very interested in the epidemic of the virus when it is possible to make good profits, moreover, the Federal Reserve is literally pushing bidders to make purchases. In addition, it cannot be ruled out that in the coming months, rates will be reduced yet again.
Goldman Sachs, for example, has already stated that it expects two more rate cuts of 0.25 at meetings in March and April. In the medium term, the probability of an uptrend is high. Until the summer, stocks can grow significantly, and then the market can begin to win back other stories. From the outside, such a view may seem overly optimistic. After all, such a strong fall could not have happened just like that, so there are serious reasons.
There really are reasons, says Igor Stremoukhov, Senior Partner at FP Wealth Solutions SA, but they have their own nature. This is not panic in the usual sense of the word, and one should not think that global investors were so afraid of the coronavirus and the economic slowdown. Now is not the year 1929 and not even the 2000 and there are no so-called “stock pits” where brokers run around and place orders like the good old days.
Funds and banks have been using trading bots and algos for a long time, they account for more than half of transactions on the exchange. The speed of movements increases, but there is also a side effect: when falling, a kind of self-destruction mechanism is launched, which could already be observed in action at the end of 2018.
Traders during the rally actively sell put options, but at the moment when the indices begin to decline, they have to reduce risks and hedge positions by selling futures or stocks included in the broader indices.
Algos do this purely on mathematical models, they are alien to emotions and other thoughts – there are only numbers. And the stronger the decline, the more they increase sales to minimize risk on options. Confirmation of this can be easily found on any options desks, where the volume of trading in American stock options was almost equal to the volume of trading in basic securities.
Thus, each decline provokes even greater sales and an even greater drop in quotes. At some point, more passive funds trigger risk management signals and they already begin to sell their portfolios. All this leads to what we saw last week. But at some point, passive funds complete the liquidation of portfolios, and the situation on the trading books of active traders stabilizes. Now the Federal Reserve is giving a helping hand to the markets, and fresh money will make it’s way into the markets.