Earlier this week the Federal Reserve, the Reserve Bank of Australia and the Bank of Canada all cut rates by 0.5 percent to face the repercussion of the coronavirus in the markets. Let’s talk first about how this pandemic has affected the markets and where investors are fleeing to seek shelter, then let’s analyze past emergency cuts to finally find opportunities to profit from these moves.
Coronavirus and the markets’ reaction
The outbreak of this virus is believed to have come from a wet market in Wuhan, China. There are other theories about how the outbreak started but we are definitely not going to go through them. This is not a conspiracy theory piece.
When the virus outbreak went global it was already an epidemic in China and they had to resource to practically shut down the country to control further spreading, unsuccessfully may I add. At the same time Japan entered a recession. Japan’s economic reality is important here because China and Japan account for 20% of global economic growth.
Globally speaking we have seen a surge in equities. Specifically in the United States, equities have rallied without a deep pullback for the entire year. In fact, the SP500 had gained 46.20% in the last 427 days. At the same time the Fed’s balance sheet had increased to $4.2 trillion from $3.7 trillion in September 2019 in what the Fed calls NOT QE.
This is important because this big rally in equities was really driven by the Central Bank’s injection of liquidity. Investors knowing this jumped into equities because of the massive return on their investments.
Where are investor fleeing?
This information is extremely important because this is, in part, how I was able to short the SP500 before that big move to the downside.
China is one of the U.S. biggest commercial partners and the U.S.-China trade deal is still not 100% complete. Now add the coronavirus effect in China to this formula and you get big slip in overall commercial activity in the U.S.. Add this to the inflated equities rally and investors fleeing equities and the US Dollar seeking safe heavens and you get a crash in the markets.
The US Dollar Currency Index has dropped 3.08% from the highs around 100 in less than 2 weeks whilst Gold soared 8.20% in the last 90 days. Bare in mind that during the majority of this big rally in Gold the US Dollar Currency Index was also rallying hard. This is extremely rare because the relation between these 2 assets is usually a correlation between moves.
This lack of correlation between Gold and the US Dollar led me to believe investors were in fact seeking shelter in Gold.
Where can we find trading opportunities?
Some might think that the rally in equities will always be true and that this crash is in fact a good buying opportunity. I would advice against this. Just have a look at the image below and how the SP500 has reacted to the last emergency rate cuts by the Federal Reserve.
In October 8th 2008 the Federal Reserve cut rates by 50 bps (0.5%) and the SP500 dropped 8.9% within a week and 17.2% within the first 6 months after the cut. It eventually rallied to end to a +7% year to date return.
If we take in consideration seasonality there is a high chance that equities will continue to tumble whilst Gold will continue to rally and this is where we should focus our attention.
Taking into consideration all the data available, the safest bet facing coronavirus is a rally in Gold.