Stock Market Gains Despite Bank Panic. Why the Storm Will Continue.

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For the stock market, the forecast calls for storms with a chance of crisis.

Stocks alternated strong rallies and sharp declines this past week amid a stretch of bank blowups and attempts to shore up the financial system. The moves in the bond market and interest-rate futures were even more extreme.

The volatile trading reflects a crisis of confidence among investors—both about troubled lenders’ ability to withstand customer deposit outflows and about the outlook for the stock market and the economy. Strangely, though, the

S&P 500 index
finished the week up 1.4%, while the

Nasdaq Composite
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%, finished the week lower. It was the first week the Nasdaq rose at least 4% and the Dow fell since 2001.

Though not reflected in the headline indexes, the lingering concern is that the interventions by financial regulators on both sides of the Atlantic—and even the banks themselves, after a consortium of financial institutions acted to prop up

First Republic Bank

(FRC)—are just a game of Whac-A-Mole, reactive one-off solutions as individual problems arise. There’s still the feeling that something more will break—and that it might not be as quick and easy to fix.

The turmoil is a consequence of the move from the previous era of rock-bottom interest rates and dampened volatility to a higher-rate and more unstable environment. For much of the past decade, low-yielding long-term investments were in vogue, as long as they offered more yield than shorter-term alternatives. But these “carry trades”—the term for borrowing at one short-term interest rate to lend at a higher, longer-term one—are a much tougher sell now that the federal-funds rate has risen to nearly 5%.

“We believe there are many carry trades that will be under pressure and it will not be possible to backstop all of them,” J.P. Morgan’s Marko Kolanovic wrote this past week. He points to commercial real estate—under fundamental pressure from e-commerce and work-from-home shifts—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 to private-equity and venture-capital business models, which may be coming under stress as well. Even credit-card and auto loans haven’t fully adjusted to a higher-rate world, and lenders there could be vulnerable.

“When the economy is slowing down and financing costs are rising, all these implicit or explicit carry trades are pressured to unwind, leading to an end of the cycle,” Kolanovic wrote.

And that unwind can be messy for financial markets. The

Cboe Volatility Index,
or VIX, jumped to nearly 30 points this past week, after spending most of the prior three months hovering around 20. The sudden spike has pushed the

Cboe VVIX Index
—yes, there’s an index for the volatility of volatility—to levels not seen in a year, after falling to its lowest reading in more than seven years in early March. It’s enough to give any investor whiplash, especially because the risks are so hard to quantify and could go either way.

“For much of last year, volatility was elevated, but the risks were somewhat ‘known’ (chiefly inflation and recession),” wrote Christopher Jacobson, a strategist at Susquehanna International Group. “Now, the introduction of the banking crisis has created a new unknown, which could ultimately mean a sharper increase in volatility (if worse than expected) or a quick reprieve (if fears prove unfounded).”

The bond market has been even more volatile. The

ICE BofAML MOVE Index
—a VIX for bonds—spiked to its second-highest reading ever this past week, behind only 2008, after doubling from its February low. That’s a reflection of the moves in Treasury yields, considered the safest, most stable asset, which have been dramatic. The yield on the two-year U.S. Treasury note has dropped by 1.2 percentage points, to 3.85%, since March 8, when it was above 5%. That stretch of trading included the two-year yield’s largest one-day fall since 1982.

The yield volatility is a symptom of traders trying to handicap the path of central bank monetary policy from here, something that seems like an impossible task. Just over a week ago, fed-funds rate futures pricing implied an 85% probability of the benchmark rate ending 2023 somewhere between 5.25% and 6%, versus 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 have shifted rapidly to a lower and closer peak and more cuts in the back half of the year.

As for the Federal Open Market Committee’s decision this coming Wednesday, the greatest odds implied by futures markets lean toward a 0.25-percentage-point increase, with about a one-third likelihood of no change. Before the confidence crisis, the debate was over whether the FOMC would hike by a quarter or half a point.

The latest inflation and other economic data argue for an increase, while the bank blowups suggest a pause may be prudent. What officials ultimately decide to do will depend on what happens between now and then. “If stresses remain, more bank issues come into view, etc. they are not going,” RBC Capital Markets Chief U.S. Economist Tom Porcelli wrote. “If things settle down a bit, they will go. That is the decision tree for the Fed. In many ways, it will be a game-time decision for them.”

Expect the market storm to continue.

Write to Nicholas Jasinski at [email protected]