Banking industry jitters could mean more pain for stocks by dragging out Fed’s battle with inflation

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Aftershocks from the collapse of three American banks in less than a week could spell more pain for stocks in the weeks ahead by creating new obstacles for the Federal Reserve in its battle against inflation, market strategists said.

U.S. authorities, including the Fed, the Treasury and the Federal Deposit Insurance Corp., jointly announced Sunday night that Signature Bank had collapsed over the weekend, following the failure of Silicon Valley Bank on Friday and the closure of Silvergate Bank on Wednesday. The plan allowed depositors at SVB and Signature to access all of their money on Monday.

The regulatory response also included a new Fed program, called the Bank Term Funding Program, or BTFP, to lend money to banks in a manner that values their collateral at par.

While many economists expect stability to return to the banking system, some market strategists worry the Fed might be forced to ease up on its interest rate hikes, dragging out its battle against inflation and potentially doing even more damage to the stock market in the process.

If the Fed halts or slows its program of rate hikes, “it will ultimately need to do more to slow things down later,” potentially creating more “instability” for markets and the economy, said Neil Dutta, head of economics at Renaissance Macro Research.

Other strategists said the trend already appeared to be manifesting in markets as investors on Monday flocked to the safety of government bonds, while the Dow Jones Industrial Average
DJIA,
-0.28%
finished lower for the fifth straight session, its longest losing streak since September.

Simon Ree, a former Wall Street trader and author of the book “the Tao of Trading,” noted that stocks weren’t responding positively to the latest drop in bond yields, a sign that investors may be growing increasingly concerned about a recession, even as investors see odds that the Fed could ease up on its rate hikes.

Treasury yields declines sharply in the past three days, with the 2-year yield
TMUBMUSD02Y,
3.984%
falling more than 100 basis points from its peak on Thursday, according to FactSet data. It stood at 4.030% on Monday afternoon in New York. down from 5% on Thursday. Bond yields and prices move in opposite directions.

Since the market opened on Thursday, the S&P 500 has fallen by more than 3%, according to FactSet data. Also, the Cboe Volatility Index
VIX,
+6.94%,
otherwise known as the Vix
VIX,
+6.94%
or Wall Street’s “fear gauge,” hit its highest level since October on Monday, according to FactSet data, climbing north of 25.

Lower bond yields that have yet to boost stocks may be a sign that “inflation concerns are taking a back seat here, and the market is more focused on a genuine risk-off sort of move,” Ree told MarketWatch.

Stocks generally have rallied in recent months on any indication that the Fed might take a less aggressive stance on interest rates. Should the Fed change its policy course due to jitters about potential contagion risks in the banking sector, it could harm stocks instead of helping them, according to Mohannad Aama, a portfolio manager at Beam Capital.

“Pausing because you think there’s systemic risk in the banking sector, or some other reason, is different than saying ‘our job is done here’,” Aama told MarketWatch by phone.

Still, should the Fed deliver another 25 basis point hike next week, as widely expected, the outlook for markets may continue to remain murky, strategists said. Investors still need to see how inflation data develops in the coming months, although they’ll receive another update on Tuesday when the February consumer-price index is released.

Economists polled by The Wall Street Journal expect to see inflation slow to a 6% pace year-over-year compared with 6.4% in January. That’s far from the Fed’s 2% annual target.

The Fed also need to monitor how quickly concerns about the stability of the banking system subside, said Steven Kelly, senior research associate at Yale’s program on financial stability, in a phone interview with MarketWatch.

Kelly expects federal authorities to succeed in restoring confidence, but “if they start announcing facility after facility, then you might need to see more dovish monetary policy,” he said.

Also, should contagion fears subside relatively quickly, markets still appear to be bracing for greater economic blowback if banks cut back on lending, according to George Saravelos, global co-head of currency research at Deutsche Bank.

“The market is sending a consistent message today: it fears that a US recession is about to start,” he said in a note to clients.

U.S. stocks finished mostly lower on Monday, with the S&P 500 index
SPX,
-0.15%
falling 0.2%, according to FactSet data, while the Dow
COMP,
+0.45%
fell for a fifth straight day, its longest losing streak since September. The SPDR S&P Regional Banking ETF
KRE,
-12.31%
fell more than 12%. The Nasdaq Composite
COMP,
+0.45%
rose 0.5%, making it the only index to finish higher.

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