Markets remain firmly in risk-off mode despite Fed action

Deep losses for European markets

The Federal Reserve's (Fed's) move overnight to loosen policy and provide a further cushion of liquidity for markets is a wise move, but in the short term the market response has been dramatic.

US markets rallied on Friday, but have already gone limit down as traders react negatively to the move. Even if the measures aren’t designed to cause a rally in equity markets, there is still a clear sense that markets are still in risk-off mode, with investors looking to cut back on equities, commodities and anything that is not the US dollar.

Europe remains the hardest hit for now, as Spain and France go into lockdown, and we have seen deep losses for all European markets. This mirrors the pattern seen in Asia overnight, and is expected to be followed by US markets when they re-open for trading.

US futures began the week on Sunday evening with an almost immediate move into ‘limit down’, having dropped 5%. This trading pause will remain in effect unless the price rebounds, and from 1.30pm onwards (UK time) the maximum fall will be 7%, before another 15 minute halt. If indices then fall 13% another 15 minute halt is instituted. Beyond this, a 20% fall in one day will result in trading being paused for the rest of the day.

Markets are dealing with a major demand shock. The prospect of people being off work in their millions, with thousands of restaurants and other businesses closed, suggests that economies around the globe will suffer big hits to gross domestic product (GDP) growth. Already data from China has shown the scale of the impact, and we can expect similar readings from other economies. Given the interconnectedness of economies, even those who escape with a low infection rate will see a hit as their trading partners enter recession.

Dollar and government bonds could be in high demand

In this environment, assets focused on global growth will be out of favour. This means equities, most commodities and high-yield bonds. Capital preservation and safe yields are the key here, so the dollar and government bonds will be in high demand, while safer equities such as utilities come into their own. Gold has not been the hedge many thought it would be, falling as investors sell their holdings to buy the dollar, and dropping further as markets worry that inflation will be weak for months to come.

At times like this, markets tend to trade on herd sentiment and newsflow. While there is still a place for reasoned analysis, fundamental investors must remember that cheap assets may get cheaper, while technical traders should bear in mind that markets are trading on momentum and headlines, and may be less inclined to respect support and resistance.

However you trade, having a process and employing risk management is crucial – in times of high volatility, wide stops and smaller position sizes are vital. At times like this, capital preservation is key, and knowing when not to trade is as important as knowing when to trade.