One of the most common questions financial professionals have fielded since March 23rd (the market bottom) is, why is the market rallying when we are in a Recession?
While there are many answers, ranging from “a better than feared health outcome” to “the market is not the economy”. The answer that is less understood outside investment circles is the old adage ‘Don’t fight the Fed.’ This refers to the notion that the US Federal Reserve has virtually unlimited powers at its disposal to provide liquidity to the market because it can print US Dollars in any amount they desire. While over the longer-term earnings and interest rates are what drive stock markets higher or lower, over the shorter-term Central Bank liquidity is a powerful tool that can take the worst outcomes off the table.
How the Federal Reserve has provided liquidity
The main way the Fed has provided liquidity is by buying US Treasuries off corporations and financial institutions in the secondary market. Bondholders essentially trade their US government IOU to the Federal Reserve for cash. This cash is then usually reinvested into either more bonds, stocks, etc., or held in cash. Importantly, the cash received from the Fed has a high chance of being invested into the financial markets because basically, you aren’t selling your bonds which you receive interest on to sit in cash which currently receives close to no interest. This liquidity injection, when large enough, provides the market confidence that the Fed will provide assistance when needed.
So far, since the end of February the Federal Reserve has bought close to $1.7Trillion worth of US Treasuries. We can see below that the large buying by the Federal Reserve occurred during the final two weeks of March and the first two weeks of April which hindsight tells us was the Market bottom (for now).
The Federal Reserve has also used other monetary tools during the Covid-19 Pandemic that will surely result in updates to economic textbooks as well as unintended consequences, however I will leave that for another day.