Recession, yes. But markets cling to hope crisis will be avoided
Rates on two-year breakevens have declined over the past few weeks
Two brutal weeks for banks have mostly scuttled hopes in markets that a US recession can be avoided. But a close read of the cross-asset landscape still finds investors unconvinced the stress portends a genuine financial crisis.
From stocks to credit to inflation breakevens and the dollar, the message is one of growing pessimism about economic growth that hasn’t morphed into panic about systemic collapse - yet. Moves like the 5.8 per cent surge in the Nasdaq 100 this week tell a tale of investors shaken by the failure of three US banks and the wobbling of Credit Suisse Group AG while resisting the sell-everything ethos that marked catastrophes like 2008’s.
“Everybody is talking in a bearish way, but they’re not acting that way,” said Matt Maley, chief market strategist at Miller Tabak + Co. “The market is definitely signaling that we’ll avoid a full-blown crisis.”
Of course, things change “- more bank failures this weekend would alter the calculus, and drawing firm conclusion from any snapshot in time is risky. Crises don’t emerge all at once. What looks placid now could be the early innings of calamity. As of now, though, the market backdrop has yet to distinguish itself from other moments that didn’t end in blowups.
For a zoomed-out picture, a global cross-asset market risk indicator kept by Bank of America Corp. jumped to the highest level since October this week while holding below levels reached during the pandemic and 2008. The metric gauges stress levels across financial markets measuring future price swings implied by option markets in global equities, rates, currencies and commodities.
“It’s not surprising with all of the dramatic events that have occurred that we are seeing quite a bit of price movement,” Lisa Erickson, head of public markets group at US Bank Wealth Management, said by phone. “Markets really are just reflecting a big level of uncertainty and we see that just through the rapid changes in pricing.”
Across markets, the most convincing sign of a recession is the plunge in Treasury yields. Sinking further Friday, the downturn was led by shorter-dated bonds, which took the entire yield curve below 4 per cent as banking turmoil led traders to price in more Federal Reserve rate hikes. But not every fixed-income instrument is flashing doom.
Rates on two-year breakevens - a proxy for where bond traders see inflation in a couple years’ time - have declined over the past few weeks after reaching about 3.4 per cent in early March. But they’re still hovering near 2.5 per cent, and that suggests to DataTrek Research a view that the economy will avoid a worse-case outcome.
“Inflation always declines in a recession, often precipitously,” Nicholas Colas, co-founder of the firm, wrote in a Friday note. “This market does not see that happening any time soon.”
Rising worry about defaults
In credit, US investment-grade corporate bond spreads widened to a five-month-high, with the Bloomberg US Investment Grade Corporate Bond Index reaching 163 basis points on Wednesday. While that bespeaks rising worry about defaults, the spreads surged past 600 during the global financial crisis and peaked at above 370 in the early days of the pandemic. While spreads have widened, it’s on the back of really narrow levels “- and only in the US, said Sanford C. Bernstein strategists led by Sarah McCarthy. That it’s hardly moved in Europe is a “reassuring sign” that these issues are “localized,” she said.
Rising interest rates have created an asset crunch, which is now at risk of becoming a credit crunch, wrote TS Lombard strategists led by Andrea Cicione. But unlike in 2008, there exist today what they called “self-stabilizing characteristics,” in which investor panic is boosting government bond prices and therefore reducing the size of the problem that created the panic in the first place.
Mixed signals
Stocks are, as usual, sending a variety of signals, some of them very worrying, such as the selloff in bank shares that has persisted even as various bailouts rolled in. At the broadest level, the moves are still subdued, far smaller than the worst swings of last year, as shown by top-down volatility. While equity turbulence as measured by the CBOE Volatility Index immediately surged above 30 in the days following Lehman Brothers’ collapse in 2008, and stayed there for eight months, peaking above 80, it now sits at 25. It spent chunks of time in 2022 above 30.
Indications of extreme stress are few. Markets really haven’t sold off, frothy parts of the market remain resilient and cyclicals are holding up well. Sure, the magnitude of volatility may have increased but all the gyrations in various classes are “normal,” said Dan Suzuki, deputy chief investment officer at Richard Bernstein Advisors, especially when the Federal Reserve is conducting such an aggressive rate-hiking campaign.
The plunge in banks and energy stocks amount to straightforward bets that the economy will contract. But the equity story is full of nuance: Since near-panic began to break out over bank liquidity last week, several industries have risen. The Nasdaq 100 notched its best week against the S&P 500 since 2008 as investors flocked to large-cap technology stocks with big balance sheets for shelter. Small caps tracked by the Russell 2000 Index were down 2.6 per cent over the past week, while the Stoxx Europe 600 fell 3.9 per cent.
“In a crisis, all stocks will go down. Therefore, instead of seeing Treasuries and big-tech stocks rallying together, we’d see only Treasuries rallying,” said Maley. “In other words, if stocks like AAPL, MSFT and NVDA rolled over in a big way, it would signal that investors had changed from looking for a place to hide, to looking for a place to avoid losses.”
Within foreign exchange, there have yet to be crisis flows to the US dollar, typically a safe-haven for nervous investors. The Bloomberg Dollar Spot Index dropped 0.5% this week, while the strongest G-10 currencies included the Swedish Krona and Australian Dollar, typically cyclically-sensitive currencies.
All that said, the financial world has been in a new era ever since central banks globally began tightening monetary policy to curb inflation. Banking turmoil is collateral damage of the cracks created in large part by the Fed itself, and it may take a while for sentiment to shift, said Louise Goudy Willmering, partner at Crewe Advisors. She expects heightened volatility in the months ahead.
“We all just need to take a breath and see where things play out,” she said by phone. “But certainly the volatility is warranted.”