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Tuesday, May 30, 2023

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Stocks have shrugged off the turmoil in the banking sector. isn’t it?

Secondfail Usually bad for business. A sick banking system will provide fewer loans and higher interest rates to companies that need capital. Tighter credit will dampen economic growth and thus profits. Sometimes bad banks wreak havoc on the financial system, causing a cascade of pain.

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Investors know this. They sold stocks when banks failed. In May 1984, the month after Continental Bank of Illinois, a large Midwestern bank, collapsed and was bailed out by the Federal Reserve, the Dow, the leading U.S. stock market index, fell 6%. In September 2008, investment bank Lehman Brothers collapsed and the stock market fell 10%. During the Great Depression, the stock market fell 89% from its peak in September 1929 to its trough in July 1932 as one bank after another failed.

This time things are different. In March, three US banks failed and deposits flowed from smaller institutions across the country. Regulators forced a 167-year-old Swiss bank into a hasty alliance with a bigger rival.However Second&p The US Stocks 500 rose 4% – a solid return well above the long-term monthly average of around 0.5%. The cheers weren’t limited to the US either: European stocks rose 3%.

The most comforting reading of these events is that the collective wisdom of the markets concludes that the danger has passed. Regulators came to the rescue, arranging deals, guaranteeing deposits and facilitating emergency loans for banks that found themselves on the rocks. Inferring investor sentiment from market movements is more of an art than a science. But is that really what people think?

Maybe not. First, it’s clear from the behavior of the interest rate market and the way different types of stocks are moving in different directions that investors aren’t betting that all is well with the banking sector or the economy. They are betting on rate cuts. The broader stock index rose as gains in the companies most sensitive to rising interest rates — namely tech giants, including Apple and Microsoft — offset plunging losses in banks and financials. Prices that dragged down the index. Nowhere was this more evident than in the performance of the Nasdaq, a tech-heavy index, which rose 7% in March.

Second, individual investors, who tend to get sucked in during the most active periods of the market, appear to be sitting on the sidelines. Retail deal flow has been on the rise since early 2021, when the frenzy for retailer GameStop ignited a slew of individual investors. Those traders bought heavily earlier this year, netting a record $17 billion of stocks in the first two weeks of February, according to data provider Vanda. But their campaign collapsed along with Silicon Valley Bank. Individuals bought a net $9 billion of stocks in the last two weeks of March, the lowest level since late 2020.

Third, and most telling, is what is happening with “swaps,” or interest rate derivatives. This allows investors to make long-term bets on possible changes in interest rates, and many use rates as a form of insurance for their portfolios: for example, take long positions in stocks but buy small amounts of swap options, large if any. Wrong. In early March, the swap options market was in balance. Investors are betting the Fed will raise rates above 6% by the end of the year, paying the same price as betting it will cut rates below 4%. But now investors are paying the price for protecting themselves from a doomsday scenario. If the Fed “capitulates” — if rates are cut by about two percentage points by December — it will cost twice as much to buy derivatives than to buy derivatives with rates climbing above 6%.

All of this points to a sense of unease overshadowed by gains in overall stock prices. Investors tend to adopt a “bad news is good news” mentality toward the end of a monetary tightening cycle, and any sign of economic distress is their friend, as it signals central banks are likely to back higher rates (or even cuts). But a fading enthusiasm among retail investors and a rush to buy catastrophe insurance suggest investors remain concerned that this round of bad news could be straight up bad news. The recovery in share prices suggests investors are hoping for the best. Activity elsewhere suggests they are also bracing for the worst.

Learn more from our financial markets columnist Buttonwood:
Did social media spark a bank panic? (March 30)
Why Markets Can Never Be Truly Safe (March 23)
Why Commodities Shine in an Era of Stagflation (March 9)

Plus: How the Buttonwood column got its name

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