Markets may be in a vulnerable position ahead of the Federal Reserve’s meeting this week, as traders bet the banking crisis could lead to meaningful interest-rate cuts over the next year.
The Fed, which on March 12 announced the creation of its emergency Bank Term Funding Program to help banks meet the needs of their depositors following the collapse of California’s Silicon Valley Bank and New York’s Signature Bank, will hold a two-day policy meeting this week. Fed Chair Jerome Powell will host a press conference after it concludes on Wednesday.
“A lot of people thought that because there was a banking crisis, it would cause the Fed to start easing monetary policy” in the coming months, said Bob Elliott, chief executive officer and chief investment officer of Unlimited Funds, by phone. He pointed to fed-fund futures, saying they show “interest rates are priced to be cut meaningfully over the course of the next year.”
But in his view, the Fed’s emergency measures helped stabilize the financial system, giving it room “to go and fight the inflation that remains too high in the economy.”
The Fed “should be tightening monetary policy,” he said. Yet economic expansion in the U.S. and inflationary pressure tied to wage growth don’t align with traders’ expectations for rate cuts over the next 12 months, according to Elliott. That leaves markets at risk, he thinks.
“The problem is that you could easily get tighter monetary policy being priced in, which would hurt both stocks and bonds,” said Elliott. He said he sees the regional bank failures stemming from “mismanagement by the leadership” that regulators did not catch, rather than Fed rate hikes.
‘Banker of last resort’
“For the first time in a long time,” the Fed has returned to its “original roots” as “banker of last resort,” said Rob Arnott, founder and chairman of Research Affiliates, in a phone interview.
“If you’re going to protect the depositors and let the stock and bond holders take the hit that they justly deserve,” he said, “that’s fine.” Describing himself as “a practical libertarian,” Arnott said “I’m totally on board with saving two or three mid-sized banks in order to prevent contagion.”
But he said he wouldn’t go so far as to say “it’s all clear,” pointing to problems at Europe’s much bigger bank, Credit Suisse Group CSGN, -8.01%, as an example. When it comes to investing in stocks, Arnott likes to buy “at peak fear.”
“Are we at peak fear in the U.S.? Probably not,” he said, adding Europe likely isn’t either.
In a sign of stress in the U.S., banks borrowed a combined $ 165 billion from the Fed’s discount window, its longstanding backstop facility, and the new Bank Term Funding Program during the week ending March 15, according to Fed data released March 16. About $ 11.9 billion was borrowed from the new Bank Term Funding Program.
In Arnott’s view, the Fed had a hand in creating the crisis partly because it kept rates near zero for too long. “They finally got religion at the beginning of 2022,” he said, with the Fed rapidly raising rates last year to battle high inflation. “So you get people addicted to free money and then crush them with expensive money,” he said. Meanwhile, “the inflation threat isn’t gone.”
Both stocks and bonds sank in 2022 as the Fed aggressively hiked rates in a bid to bring the surging cost of living under control.
While inflation has come down this year, it remains high, and Arnott anticipates it may wind up being stickier in the second half of 2023 when year-over-year comparisons become more difficult. As a result, the rate of inflation could end the year in the range of 5% to 6%, he estimated.
The market is largely expecting the Fed will announce Wednesday that it’s raising its benchmark rate by a quarter of a percentage point to a target range of 4.75% to 5%. Fed-funds futures on Friday indicated a 62% chance of that sized rate hike and 38% odds of a pause, according to CME FedWatch Tool.
‘Needle mover’
Liz Ann Sonders, chief investment strategist at Charles Schwab, said in a phone interview that the “needle mover” for whether the Fed lifts its benchmark rate by a quarter of a percentage point or pauses will be “any additional fallout from what’s going on in the banking system.”
The Fed will announce its policy decision Wednesday at 2 p.m. Eastern, with Powell holding a news conference at 2:30 p.m.
See: Fed likely to follow ECB’s playbook and hike interest rates next week
It wasn’t that long ago that Powell, in his March 7 testimony before Congress on monetary policy, opened the door to possibly accelerating the pace of rate hikes at its upcoming meeting due to inflation worries.
Now it’s “a complicated situation” because of financial stability concerns, said Sonders. She said she expects lending conditions will continue to tighten in the wake of the Fed’s aggressive rate increases over the past year and recent bank woes.
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“It’s easy to argue that credit conditions get even tighter from here,” Sonders said. “I think we’re just at the beginning of basically creative destruction.”
Still, the Federal Reserve Bank of Atlanta’s GDPNow tracker estimated on March 16 that the growth rate of real gross domestic product in the first quarter was 3.2%.
Some investors expect that a recession may be looming as a result of the Fed’s aggressive rate hiking campaign, and the economic contraction will help bring down inflation.
Yet to Elliott, the U.S. appears “at least as far away from recession” as it was three or six months ago. And based on the 100 basis points of “easing” he saw priced in the market over the next 12 months, he said even a pause in the current tightening process could lead to a selloff in bonds and likely be “a drag on the stock market.”
Within equities, Arnott said value stocks look cheap relative to growth stocks and should fare better in an environment with inflation pressures. But the Russell 1000 Growth Index RLG, -0.60% has jumped 8.7% this year through Friday, while the Russell 1000 Value Index RLV, -1.79% has dropped 4.4% over the same period.
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The narrative that rates will come back down, and stay down, has helped fuel the rise in growth stocks, said Arnott, but he described it as a “short-term phenomenon.” Viewed over a longer horizon, value stocks appear “very cheap” relative to growth equities, he said. Plus, inflation, which remains a worry, “works to the benefit of value, not growth.”
While stocks and bonds were hurt by rising rates last year, Phil Camporeale, a portfolio manager at JPMorgan Chase & Co., told MarketWatch that he’s recently seen fixed income play a defensive role in the tumult from the banking sector.
The ability for bonds to “provide ballast and defense in times of equity weakness is something that we care a lot about,” said Camporeale, who’s a portfolio manager for J.P. Morgan Asset Management’s global allocation strategy, by phone. “We really are benefiting from the negative correlations between stocks and bonds over the past week” or so, he said.
U.S. stocks ended lower Friday amid persisting banking sector fears, with the Dow Jones Industrial Average DJIA, -1.19% booking back-to-back weekly losses. The S&P 500 SPX, -1.10% rose 1.4% for the week, while the technology-heavy Nasdaq Composite COMP, -0.74% climbed 4.4% in its biggest weekly percentage gain since January, according to Dow Jones Market Data.
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Treasury yields plunge
In the bond market, Treasury yields fell Friday and tumbled for the week as they extended their slide from their recent 2023 peaks. Bond prices rally when yields fall.
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The yield on the two-year Treasury note TMUBMUSD02Y, 3.824% plummeted 74 basis points last week to 3.846% on Friday in its biggest weekly decline since October 1987 based on 3 p.m. Eastern time levels, according to Dow Jones Market Data. Further out on the Treasury yield curve, 10-year Treasury rates TMUBMUSD10Y, 3.430% saw a weekly drop of 29.9 basis points to 3.395%, the lowest level since January.
“The chances for aggressive rate hikes have been diminished” as a result of the recent bank turmoil, with the Fed potentially “very close” to the end of its tightening cycle, according to Camporeale.
The tumult in the banking sector may “do some financial condition tightening for the Fed and has the potential of being disinflationary from the sheer standpoint of business caution,” he said. For example, regional banks may be more cautious lending due to the sector’s woes, he said.
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But Camporeale, who within fixed income is favoring longer duration government debt and U.S. investment-grade corporate bonds, said it’s still “too early to declare an end to the tightening cycle.” That’s because inflation remains high, he said, though “as long as inflation isn’t running away, we would expect the long end of the curve to remain pretty much anchored.”
It’s also “premature to price in easing” of the Fed’s monetary policy, according to Camporeale. “I can’t say if the Fed is going to be easing in the back half of the year just yet,” he said.
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