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Investor Strategy

Fed Rate Cut: Overreaction Or Necessity?

European markets are likely to remain volatile due to another set of weak economic numbers out of China. The Chinese Caixin PMI number fell to 26.5, a fear-mongering level.

The Fear of the Unknown

There is some serious trouble brewing, and traders are not aware of what is to come. This is the message that investors took away from the Federal Reserve’s surprise action yesterday. The Fed delivered the biggest emergency interest rate cut since the financial crisis and it was completely unexpected. A traditional textbook trade would have pushed the stocks higher, blasting the roofs and ripping all the previous highs. However, there was nothing close to this level, markets took the message as a sign of panic. As a result of this, the Dow Jones index plunged by over 700 points and closed lower with a loss of 2.94%, the S&P 500 dropped 2.81% and the NASDAQ fell 2.99%.

We think that the Fed has overreacted just like the markets have. The reason that we say that is because we do not see much evidence of a liquidity crisis, the coronavirus crisis is more of a health issue. Basically, the coronavirus situation is nothing more than a knowledge gap, we do not know the exact numbers of people who are infected or numbers of people who have recovered. More importantly, the economic impact of this virus is still very much unknown.

Yes, the Fed has made some room for itself in order to have that competitive edge–the Fed never pushed the interest closer to zero. Last year, it lowered the interest rate three times and it remained very much data-dependent. The aggressive monetary policy move has left the Fed with limited room for any further response. This is because the 50-basis points rate cut was extremely aggressive, and this put more pressure on the Fed especially if the economy starts to deteriorate.

Too Much Ammunition Used

I think we can classify the Fed action as preemptive and too aggressive. The Fed has used its ammunition a little too early and this has left very few other options on the table when the interest rates are already too low. Having said this, this is a time when central banks need to be data-dependent and not let their emotions carry them away. The fact is that the second-biggest economy is slowing down rapidly, workers have not returned to their factories, the supply chain is massively disrupted and the economic numbers have started to flash some signals which we have not seen since the financial crisis. There is no doubt that the spillover effect is going to influence the US economy, but so far, we have not seen the data falling off the cliff. All that we needed from the Fed at this time was their support in terms of language and very little action.

Gold Moves Higher

In the commodity space, the gold price surged massively on the back of the Fed’s reaction. The intensive move in the gold price was mainly due to the fact that the market participants have started to think that the Fed is going to act like the Bank of Japan and the European Central Bank. If this view becomes mainstream, meaning if we see more rate cut or consistent dovish language from the Fed, I think it would provide a very strong tailwind for the gold price to reach a level which we have not seen before–ripping the all-time high levels.

The number to watch in terms of economic data is the US ADP number which is going to set the tone for the upcoming US NFP data. It is expected to come in soft with a reading of 170K against the previous reading of 291K. A weak reading is going to boost the gold price and it likely that we may see the price move to 1670 mark because speculation will grow for the Fed dovish monetary to remain in place.

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