It’s suddenly become tougher for investors to peer across the valley toward a more welcoming landscape. At the start of this year and into last week, markets have been able to look through the recession precursors and historic jump in bond yields toward the presumptive end of the Federal Reserve tightening cycle and a potential benign economic outcome — emboldened by a handful of rare momentum and breadth signals that have tended to show up only when the tape was embarking on an important upturn. As recently as a week ago, I gave the market credit for its resilience and noted the reassuring leadership of economically sensitive groups which followed the textbook bottoming action in October. Now, after the run on the parent of Silicon Valley Bank injected some panic into an already tiring market, the uptrend since October has buckled for now, the macro narrative has been scrambled by new financial-stress fears and the S & P 500 is back closer to the lower end of its sloppy ten-month range. The pullback since the high five weeks ago has now been deeper than after almost any prior instance of those uncommon technical breadth indicators. To sum up, the S & P 500 built up a pretty nice cushion with an 8% surge by Feb. 2, and has now almost fully compressed it, the bulls making full and spendthrift use of whatever benefit of the doubt they’d accrued. This isn’t “game over” for the prospect of October’s low standing as a durable one or for this fitful multi-month rally phase. The S & P 500 is still up fractionally on the year, and there were some signs of a panicky washout in the pre-weekend liquidation in bank stocks that could leave the market tightly coiled for a relief trade if no further major casualties emerge by Monday. Still, the burden of proof is growing on the optimists. The charts suggest that breaking the December low in the S & P 500 around 3765 – down just 2.5% from here – would lose the bullish case a lot more credibility than has been surrendered so far. But we’re not there yet. No bulls should be particularly confident, but federal regulators did place a $200 billion bank that was an S & P 500 index member into receivership and the index simply backed off to where it was the first week of the year. Of course, fears of contagion can outrun the facts and sometimes can become self-fulfilling, but the S & P 500 has (for now) simply backslid to a nine-week low. With that as the broad market setup, a couple of themes that have emerged during this latest market squall: Interaction between stocks and bonds changed Since the market peak early last year, equity and bond prices were falling mostly in tandem during the Fed’s urgent rush to jack up rates to fight galloping inflation — the prime source of pressure on stocks and the economy. The asset classes diverged occasionally, but mostly in degree rather than direction. Then last week, the stampede into Treasuries as a haven from financial-contagion fears and related expectations that the Fed would not hike rates by half a percentage point on March 22 sent yields rushing lower – even as stocks had their worst week of the year. For sure, this flipped correlation is only a few days old and could shift again, especially with a Consumer Price Index report on Tuesday coming with Fed officials in their pre-meeting public-comment blackout period. But it could be a notable turn from the Fed and rates being the chief adversary of stocks to weaker growth and potential financial-market instability becoming the primary enemies. Jason Hunter, technical strategist at JP Morgan, had been expecting “a weakening corporate earnings environment would eventually take the narrative away from the Fed driven rates market. That transition would be marked by the breakdown in the positive correlation between bond and equity prices and the start of an impulsive bull steepening trend for the Treasury curve.” Whether last week was the start of this phase or just a blip, Hunter says, “We think the transition is inevitable and will unfold in the weeks/months ahead.” The deeply negative Treasury yield curve (with short yields way above long-term ones for months) did begin to narrow as short-term yields plunged and the market projected a higher chance of Fed easing in the year ahead. This is yet another precursor to past recessions, for what that’s worth. Hunter believes further equity weakness will eventually put in place “a cycle bottom in stocks in the months ahead,” but not quite yet. As a side note, is Big Tech showing itself to be defensive again? The Nasdaq 100 has not given up nearly as much of its New Year’s rally and semiconductors as a group look sturdy. A market in which Apple outperforms is likely not a particularly generous one for the broader tape, and vice versa. In the past week Apple shares lost about a third of what the S & P 500 did. When the Fed “breaks” things The descent of SVB Financial into receivership mere days after realizing losses on a bond portfolio and raising some fresh equity capital naturally prompted the now-familiar reminders that the Fed typically tightens policy until something significant ruptures in the financial system or the economy. For sure this has been true in past cycles, even as the magnitude of the accidents has varied widely. But it’s not a sure thing that the regional-bank mini-panic now is a decisive mishap that will reverberate profoundly or for very long. As has been widely noted, SVB is an extreme, if not fully unique, version of the regional-bank experience at the moment, with an unusually concentrated and connected depositor base and far more assets in underwater bonds than is typical. For sure, the pressures among smaller banks to pay up to keep deposits while marking down commercial-real-estate assets will surely claim some victims. Still, note that SVB wouldn’t even be the first thing said to have been “broken” by the Fed this cycle. Crypto assets lost $1 trillion in value and the largest exchange was seized as an alleged fraud. In October, a massive hole was blown in the U.K. pension system as rates surged there, spurring predictions of a solvency crisis. Also, around the autumn market lows, Credit Suisse was reported to be in distress and some Cassandras were invoking Lehman Brothers as a comp. Those blows have been absorbed reasonably well. And just to indulge some historical reminiscence, the last time the Fed executed anything like the current accelerated tightening campaign, in 1994, there was breakage galore in the fixed-income markets. A whole class of short-term bond funds engineered with exotic securities to offer above-average yields and sold as cash substitutes were decimated by higher rates. The brokerage Kidder Peabody was hobbled by a mortgage-trading scandal when the market was roiled. Procter & Gamble and Gibson Greetings booked big losses on fixed-income derivatives. And, in a culminating cataclysm, Orange County, Calif. went bankrupt after suffering losses on derivatives that were effectively levered bets on rates staying low. Less than two months after the county declared bankruptcy — and just about on the anniversary of its first rate-hike of the cycle — the Fed lifted short-term rates one last time by 50 basis points and then went on hold, allowing the economy to prove it could land softly. Of course, there are way more differences than parallels between now and 1994-5. Inflation has been at generational highs for two years as it was not then, and the labor market wasn’t nearly as tight. As for the current concern about the lagged damage of Fed actions, the interplay of market psychology around unstable balance sheets and policy flux can create a volatile weather system. But there are always far more passing scares in markets than there are mega-storms that make landfall.
