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The fallout from the closure of three U.S. banks in the span of a week is making it near-impossible for analysts to determine a fair valuation for stocks, as volatility in the U.S. government bond market surges to its highest level in nearly 15 years, market strategists say.
That is due in part to increasing uncertainty around how the Federal Reserve will react going forward as it attempts to balance a spate of risks to markets and the economy.
If you can’t price bonds, you can’t price stocks
At the root of the problem is the ICE BofAML MOVE Index, a gauge of implied volatility in the Treasury market. The index surged to 174 on Tuesday, its highest level since the middle of 2009, according to FactSet data, as yields gyrated wildly. Between Thursday morning and Monday evening, the yield on the 2-year Treasury note
TMUBMUSD02Y,
had plunged more than 100 basis points before rebounding, a wild gyration that investors said was extremely atypical for the world’s most-liquid market for sovereign debt.
This essentially means traders of Treasury options and interest-rate swaps are bracing for the yield on the 2-year Treasury note to swing by 12 or 13 basis points on average every day over the coming months. When market conditions are more placid, these rates typically see much smaller moves of between two and three basis points a day, said Scott Ladner, chief investment officer at Horizon Investments.
“What the market is telling you is ‘we don’t know how to price the risk-free asset,’” Ladner said during a phone call with MarketWatch. “If the market can’t price a risk-free Treasury bond, please don’t ask me to price a stock. “
The 2-year yield stood at 4.217% late Tuesday in New York. Bond yields move inversely to prices, and some analysts expect these wild swings could persist in the coming days, weeks and months as investors struggle to parse the Fed’s next move.
As MarketWatch explained last month, shifting bond yields have a major impact on equity valuations because of a concept in finance known as the equity risk premium — that is, the reward investors receive for buying riskier assets like stocks instead of “risk-free” assets like Treasury bonds.
Of course, the notion that Treasury bonds are considered “risk free” doesn’t mean they’re insulated from losses. But they’re seen as a safer investment, in part because investors can typically recoup their money by simply holding a bond to maturity.
Murky outlook spurs range of perspectives
The now-murky outlook for Fed policy could continue to make life difficult for investors in a number of ways.
As analysts attempt to anticipate how the Fed might seek to balance the need to continue fighting inflation with fears of causing more damage to the U.S. banking system, economists at different investment banks have come up with a range of views for what the Fed might do at its next policy meeting, which concludes on March 22.
Economists at Goldman Sachs Group
GS,
NatWest and Barclays
BARC,
expect the Fed won’t raise rates at all. Asset-management giant BlackRock Inc.
BLK,
still expects a rate hike, as do economists at Citigroup Inc.
C,
and JPMorgan Chase & Co.
JPM,
At least one bank — Nomura Holdings
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— said it expects the Fed to cut interest rates by 25 basis points while announcing plans to stop shrinking its balance sheet.
This plurality of views mirrors the volatility in Fed funds futures, which traders use to place bets on changes in Fed policy, over the past week.
Just one week ago, traders saw a high probability that the Fed would hike interest rates by 50 basis points in March for the first time since December. At one point, these market-based odds had shifted in the opposite direction, with traders seeing about even odds that the Fed would leave rates on hold, or opt for a smaller, 25-basis-point hike, like it did in February.
Odds now favor a 25-basis-point hike, although traders still see a 35% chance that the Fed will keep interest-rates unchanged, according to the latest data from the CME’s FedWatch tool.
Rate cuts back on the table
At the start of the year, investors largely expected the Fed would cut interest rates later in 2023, but a spate of hot data on the state of the U.S. economy, the labor market and inflation effectively forced them to change their minds. At one point, market-based expectations saw the terminal rate climbing as high as 5.5% before the end of the year.
But a series of bank failures in the U.S has stymied this shift toward higher rate expectations.
Problems started when Silvergate Bank closed its doors last Wednesday due to issues with its client base of cryptocurrency firms. The crisis accelerated when Silicon Valley Bank was taken over by federal authorities on Friday following a panic-induced run on deposits which also caused shares of regional banks to crater.
On Sunday night, the Federal Deposit Insurance Corporation, along with the Treasury Department and Federal Reserve, announced that a third lender, New York’s Signature Bank, had also failed. To try and stem the panic, the authorities said that depositors at both Signature and SVB would be able to access all their deposits on Monday.
Since the Fed’s aggressive interest-rate hikes over the past year helped ignite the crisis by forcing banks to brook large marked-to-market losses on their bond portfolios, investors and analysts now expect that the Fed will be more circumspect going forward for fear of sparking another crisis.
Mohamed El-Erian, chief economic adviser at Allianz, described the Fed’s difficulties as stemming from a “trilemma” — or the fact that it must now attempt to balance three competing priorities: “delivering low inflation, minimizing damage to growth and avoid unsettling financial instability,” he said in a Tuesday tweet.
Fed funds futures expect the Fed funds rate target will end the year between 4.25% and 4.5% after peaking at between 4.75% and 5% in June. That would suggest that the market only sees one more 25-basis-point hike before the Fed pauses.
The result of this is that the Fed might find itself boxed in, no longer able to be as aggressive in fighting inflation as it would have liked to be.
“I feel very confident that if the SVB hadn’t failed, the market would have started to price in a terminal rate of 6% in the coming months,” said Stephen Miran, a co-founder of asset-management firm Amberwave Partners and a former senior adviser at the U.S. Treasury who served under then-Treasury Secretary Steven Mnuchin. Miran spoke with MarketWatch on Tuesday to discuss the details of the latest CPI data.
CPI justifies a 50-basis-point hike
Under normal circumstances, the CPI report released on Tuesday could easily justify the Fed to shift back to rate hikes of 50 basis points, according to several market strategists.
The CPI data suggested that the worst inflationary wave in more than 40 years continued to slow in February. But some stock-market analysts were troubled by what they saw beneath the surface.
On a year-over-year basis, the CPI number showed the pace of consumer-price inflation over the prior 12 months slowed to 6% in February, down from 6.4% in January.
But the pace of services inflation appeared unsettlingly strong. So-called “supercore” services inflation — which strips out rents to focus on transportation, health-care and other prices —increased by 0.5% on a month-over-month basis in February, compared with a rate of between 0.3% and 0.4% in January.
Meanwhile, so-called “core” CPI, which excludes volatile food and energy prices, expanded at a pace of 0.5% on a month-over-month basis in February, compared with expectations for a gain of just 0.4%.
Neil Dutta, head of economics at Renaissance Macro Research, said in a note to clients on Tuesday that the latest data should have cemented the case for the Fed to hike rates by 50 basis points next week. But instead, Dutta expects they will opt for a 25-basis-point hike, which could lead to problems down the road.
“Today’s CPI data are a reminder that the inflation fight is not over…there is a risk that inflation pressures become entrenched, which could lead to more financial instability later,” Dutta said in emailed commentary shared with MarketWatch.
A silver lining
If there’s a silver lining to be found, its that — so far, at least — the banking systems’ woes are helping to stoke expectations that inflation could slow more rapidly in the coming months, according to a few market-based gauges.
One of these is the five-year breakeven inflation rate, a proxy for what investors expect the pace of inflation to be five years from now, fell to 2.26% on Tuesday, according to data from the St. Louis Fed. The breakeven represents the spread between a five-year nominal Treasury note, and the yield on the Treasury Inflation Protected Security.
Short-term inflation expectations have fallen by an even greater degree, showing the biggest drop since the advent of the COVID-19 pandemic, according to Callie Cox, a U.S. investment analyst at eToro.
“Investors seem to think the fear of financial instability could make consumers and businesses more cautious. And in theory, an air of caution could do the Fed’s job for them,” Cox said.
U.S. stocks advanced on Tuesday, helping to pare some of their losses from the past week.
The S&P 500
SPX,
gained 64.80 points, or 1.7%, to 3,920, while the Dow Jones Industrial Average
DJIA,
rose by 336.26 points, or 1.1%, to 32,155.40. The Nasdaq Composite
COMP,
meanwhile, gained 239.31 points, or 2.1%, to 11,428.15, according to FactSet data. All three benchmarks are still in the red since the beginning of March.
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