March 17, 2023

Markets were whipsawed after a tumultuous week in which the collapse of three regional banks exposed the pressures of rising rates on the U.S. banking system. Regulators moved swiftly to stem fears of broader market contagion and to shore up the financial system.

Despite the volatility the S&P 500 ended the week up 1.4%. Expectations for lower rates helped the Nasdaq Composite advance 4.4%, its best week since November, while the banking sector remained under pressure, with the KBW Bank Index down 9.4% for the week.

Meanwhile, volatility in the bond market soared to levels not seen in 15 years. The two-year Treasury note yield plunged to a low of 3.71% earlier in the week, before ending at 3.84%, while the 10-year Treasury yield finished at 3.43%, down 30 basis points.

What This Means for the Fed

All eyes are focused on the Fed as it attempts to balance the need to maintain financial stability with its battle against inflation. The market is currently expecting a 25 basis-point rate hike on March 22, down from expectations of 50 basis points just a week ago.

The Fed may stress the distinction between the tools it uses to maintain financial stability and the rate hikes it uses to contain inflation, so that it can continue to simultaneously address both issues.

Federal fund futures have undergone a major turnaround, from forecasting a 5.6% terminal rate after Fed Chair Powell’s hawkish testimony to Congress on March 9, to 4.75% this week. Futures markets are also pricing in 75 basis points of rate cuts by year-end to 4.00%, in anticipation that a pullback in lending by small- and medium-sized banks may cause a recession and prompt a Fed pivot.

Our View

The inflation fight is not over: The Fed has signaled that it will not pivot until there are multiple signs that inflation is consistently trending lower. This week, the Consumer Price Index for February showed prices moderated but remained sticky amid strong consumer demand. January and February’s payrolls were also much hotter than expected, and while retail sales softened in February, consumer spending is still powered by savings amassed during the pandemic, as well as strong wage growth.

One and done: We think the Fed will raise rates another 25 basis points, either next week or in May, and then keep rates at that level until inflation is consistently trending toward its 2% target.

A recession is more likely later this year than next year: We expect regional banks will be subjected to far greater regulatory oversight and are likely to tighten lending standards with a downshift in risk appetite. A contraction in regional bank lending is likely to lead to an economic slowdown.

Equity markets could retest last year’s lows: If lending standards are tightened and growth slows, then we expect an impact to corporate earnings and a re-test of 2022’s market lows, as the market prices in a recession.

Bonds continue to offer attractive yields: At the beginning of the year, we recommended increasing our fixed income allocation now that higher yields provide income and a ballast for portfolios.

The Bottom Line

The Fed’s decision to provide banks more liquidity at its discount window has gone a long way to comforting market participants that regulators have the tools to navigate the crisis.

Nevertheless, volatility will continue until regulators can ringfence the crisis of confidence in the regional banking sector. The damage to real activity may have already happened and we expect the regional banking problems to push the U.S. economy into a mild recession later this year.

Our portfolios are positioned for volatility. Our neutral weightings in equities and fixed income, as well as a small overweight to diversifiers, helps protect principal and allow us to take advantage of price dislocations caused by volatility. As always, we are here to help guide you through these challenging markets and to discuss your portfolio.

Please join Chief Investment Officer, Leo Grohowski for a webcast on March 22nd at 4:00pm ET to hear our initial thoughts on the Fed’s decision and the market's reaction.