For the stock market, forecasts announce storms with a risk of crisis.
Stocks have alternated between sharp rises and steep declines over the past week amid a series of bank blasts and attempts to consolidate the financial system. Movements in the bond market and interest rate futures were even more extreme.
The volatility in trading reflects a crisis of confidence among investors, both in the ability of troubled lenders to withstand customer deposit outflows and in the outlook for the stock market and the economy. Strangely, however, the
S&P 500 Index
ended the week up 1.4%, while
Nasdaq Compound
gained 4.4% as stocks like Apple (ticker: AAPL) and Microsoft (MSFT) benefited from a flight to safety and falling bond yields boosted growth stocks. Only the
Dow Jones Industrial Average,
which fell 0.15%, ended the week down. It was the first week the Nasdaq rose at least 4% and the Dow Jones fell since 2001.
Although not reflected in the major indices, the lingering concern is that interventions by financial regulators on both sides of the Atlantic – and even by banks themselves, after a consortium of financial institutions acted to supporting First Republic Bank (FRC) – are just a game of Whac-A-Mole, reactive point solutions as individual issues arise. There’s always the feeling that something more is going to break and it might not be as quick and easy to fix.
The turmoil is a consequence of the shift from the previous era of low interest rates and reduced volatility to an environment of higher and more volatile rates. For much of the past decade, long-term, low-return investments were all the rage, as long as they offered more returns than short-term alternatives. But those “carry trades” — the term for borrowing at a short-term interest rate to lend at a higher, longer-term rate — are much harder to sell now that the fed funds rate has risen to nearly by 5%.
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“We believe that many carry trades will be under pressure and it will not be possible to sustain them all,” JP Morgan’s Marko Kolanovic wrote last week. He cites commercial real estate – under fundamental pressure from e-commerce and working from home – as an example of an attractive investment in a zero-rate world whose problems become apparent as rates rise. Low-cost funding has also been a huge tailwind for private equity and venture capital business models, which could also come under strain. Even credit card loans and auto loans haven’t fully adapted to a higher rate world, and lenders could be vulnerable.
“When the economy slows and funding costs rise, all of these implicit or explicit carry trades are forced to unfold, leading to the end of the cycle,” Kolanovic wrote.
And this outcome can be messy for the financial markets. THE
Cboe Volatility Index,
or VIX, jumped to nearly 30 points last week, after spending most of the previous three months around 20. The sudden spike pushed the
Cboe VVIX Index
— yes, there is a hint for volatility in volatility — at levels not seen in a year, after falling to its lowest level in more than seven years in early March. That’s enough to give any investor a boost, especially because the risks are so hard to quantify and can go either way.
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“For much of the past year, volatility was high, but the risks were somewhat ‘known’ (mainly inflation and recession),” wrote Christopher Jacobson, strategist at Susquehanna International Group. “Now the introduction of the banking crisis has created a new unknown, which could ultimately mean a sharper rise in volatility (if worse than expected) or a quick reprieve (if fears prove unfounded).”
The bond market was even more volatile. THE
ICE BofAML MOVE Index
– a VIX for bonds – hit its second-highest level on record last week, behind only 2008, after doubling from its February low. This reflects movements in Treasury yields, considered the safest and most stable asset, which have been dramatic. The yield on the two-year US Treasury note has fallen 1.2 percentage points to 3.85% since March 8, when it was above 5%. This trading period included the largest one-day decline in two-year yield since 1982.
Yield volatility is a symptom of traders trying to handicap the path of central bank monetary policy from here, which seems like an impossible task. Just over a week ago, pricing for fed funds rate futures implied an 85% chance that the benchmark rate would end in 2023 between 5.25% and 6%, compared to the current target range of 4.5% to 4.75%. Today, the odds imply a year-end fed funds rate between 2.75% and 3.25%. Expectations quickly shifted to a lower, closer peak and more cuts in the second half of the year.
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As for the Federal Open Market Committee’s decision next Wednesday, the largest futures markets implied odds are leaning toward a 0.25 percentage point increase, with about a third chance of no change. . Before the crisis of confidence, the debate was whether the FOMC would rise by a quarter or half a point.
The latest inflation data and other economic data argue for an increase, while banking blasts suggest a pause may be prudent. What officials ultimately decide to do will depend on what happens between now and then. “If the strains persist, other banking problems appear, etc., they won’t,” wrote Tom Porcelli, chief economist at RBC Capital Markets in the United States. “If things calm down a bit, they will leave. This is the Fed’s decision tree. In many ways, it will be a game decision for them.
Expect the storm in the markets to continue.
Write to Nicholas Jasinski at nicholas.jasinski@barrons.com