Navigating the Current Financial Market: Implications for Investors

As we enter the second quarter of 2023, many investors may be confused about the current situation in the financial market. Inflation is on the rise, the Fed is continuing with its interest rate hikes as well as quantitative tightening, and banks are also facing liquidity and balance sheet issues. In this blog post, I will break down these factors and their implications for investors.

Firstly, it is essential to note that while these factors may seem worrying, the risk of a recession remains low. Even if one were to occur, my opinion is that it would be a short-term V-shaped recovery. This conclusion is based on my observation that many investors and institutions had kept their funds on the sidelines due to the continuous interest rate hike. As a result, the Fed's reserve repo agreements have increased to over $2 trillion. This means that once interest rates decrease, investors/institutions will reverse their actions and start investing more aggressively (Previously mentioned in this and this blog post).

Source: Fed Overnight Reverse Repurchase Agreements (as of 27 Mar 2023) - USD 2,220.131 bn

However, for the Fed to reduce interest rates, a recession has to occur. A preemptive action to a recession has already started, with banks requiring government assistance to boost their liquidity and support their current balance sheets. Fed has also stepped in by offering the Bank Term Funding Program, increasing its balance sheet by allowing banks to pledge their bonds or mortgage-based securities to the Fed, which will provide the liquidity they need in return.

It is essential to note that the current ballooning of the Fed's balance sheet is not quantitative easing in 2020, where funds went directly to people. Instead, this is more like quantitative easing in 2008, where funds go to corporates/institutions through banks. 

Banks will do credit analysis on the applications and only lend to those with lower credit risk. Since not everyone will received the funds and only the better quality corporates/institutions will received these funds, these funds will be used for a much better purpose - resulting in a potential higher return on the usage of the funds for the future.

To summarize, I perceive the current expansion of the Fed's balance sheet as a measure to counteract the adverse impacts it has already inflicted on the economy. At the same time, it could potentially stabilize the economy and even kickstart a bullish trend. Therefore, I will continue to standby my view that risk of recession remains low, and may even be lower with this new Bank Term Funding program.

Finally, as investors, it is crucial to understand that the current situation is not all doom and gloom. The market will eventually rebound, and investors need to keep a level head and not make hasty decisions based on the current situation. The economy is constantly evolving, and we must adapt to the changes to make informed investment decisions.

Stay Tuned.