Analysis-Bank disquiet, Fed keep investors on edge in nervy U.S. stock market

© Reuters. FILE PHOTO: The Federal Reserve building is pictured in Washington, U.S., on March 19, 2019. REUTERS/Leah Millis/File Photo

By David Randall

NEW YORK (Reuters) -Investors are preparing for a long U.S. stock market slog, braced for more banking sector tumult and worries over how the Federal Reserve's tightening will impact the economy.

Financial stocks in the United States experienced sharp moves throughout the week after the collapse of two U.S. lenders and last weekend's Swiss-government-orchestrated takeover of troubled Credit Suisse by rival UBS.

"Volatility will continue because we still don't know the extent of the disruptions with in the banking sector," said Cameron Dawson, Chief Investment Officer at NewEdge Wealth.

Many worry that other nasty surprises lurk as the rapid series of interest rate hikes the Fed has delivered over the past year dry up cheap money and widen fissures in the economy.

"Investors are acting first and looking into the nuances later," said Wei Li, global chief investment strategist at fund giant BlackRock (NYSE:BLK). "It's understandable because it’s not super clear that this is definitely contained."

In recent days, investors focused on Deutsche Bank (ETR:DBKGn), whose shares have lost around more than a quarter of their value this month, including Friday's 8.5% fall, and the cost of protecting against a default on its bonds soared, even though few put it in a class with Credit Suisse.

"We are not concerned today about counterparty, liquidity issues" with Deutsche, JPMorgan (NYSE:JPM) analysts said on Friday.

For now, few investors see this year's events as a repeat of the systemic crisis that swept through markets in 2008, taking down Lehman Brothers and prompting government bailouts.

But investors are wary of another bank run if people think U.S. or European regulators will not step in to shield deposits.

"It's almost like the prisoner's dilemma where if everyone agrees that they won't pull their deposits then everything should be okay, but if just one person decides they are getting out then the snowball keeps growing," said Tim Murray, capital market strategist in the Multi-Asset Division of T. Rowe Price.

Murray is underweight equities, focusing on money market accounts that offer yields comparable to Treasuries.

'HIGHLY UNUSUAL'

Apollo Global Management (NYSE:APO) Chief Economist Torsten Slok said the growing divergence between the Fed fund's rate and the far lower interest rate on checking accounts is increasing the risk of bank deposit outflows. The Fed raised rates by 25 basis points on Wednesday to the 4.75% to 5% range.

"Higher rates as a source of instability for deposits and Treasury holdings is highly unusual compared to previous banking crises, where the source of instability has typically been credit losses putting downward pressure on the illiquid side of banks’ balance sheets," he wrote in a note on Saturday.

Data released on Friday by the Federal Reserve showed that deposits at small U.S. banks dropped by a record amount following the collapse of Silicon Valley Bank on March 10.

Meanwhile Federal Reserve emergency lending to banks, which hit record levels, remained high in the latest week amid ongoing anxiety, data released Thursday showed.

"We're watching very closely all of the data about how much liquidity is being drawn from the Fed’s different facilities," said Dawson. "If we continue to see the usage of these facilities, it could point that more banks are feeling funding constrains or liquidity needs, which means that the contagion may not be over.”

U.S. authorities are considering expanding a bank emergency lending facility in ways that would give First Republic Bank (NYSE:FRC) more time to shore up its balance sheet, Bloomberg reported Saturday, citing people with knowledge of the situation.

'CRISIS OF CONFIDENCE'

Uncertainty over the Fed's intentions is also amplifying investor hesitation in stocks and sparking huge swings in U.S. government bond prices, after policymakers indicated they were on the verge of pausing further increases as banking sector worries risk tightening economic conditions.

Investors piled into the safe haven of U.S. Treasuries over the past week, sending yields on the two-year note, which closely reflects Fed policy expectations, to 3.76%, the lowest since mid-September.

Further banking industry failures could mean rate cuts sooner as weakened financial conditions allow the Fed to ease up on its fight against inflation, said Tony Rodriguez, head of fixed income strategy at Nuveen. Futures contracts suggest the Fed will start cutting rates by year-end.

Falling interest rates would make dividend-paying stocks and some riskier assets such as higher-quality below-investment-grade bonds attractive, Rodriguez said.

Risk assets have been somewhat resilient despite the concerns in the banking sector, said Jason England, global bonds portfolio manager at Janus Henderson Investors. The S&P 500 is up 3.4% this year, though far off its early February highs, and it rose 1% this week, helped by a rally in tech shares.

"If inflation comes down because of disruptions in banks and you create tightening for homeowners, the Fed suddenly has its work done for it," he said.

England expects longer-duration bond yields to start to rise from current levels, making short-term bonds and money market funds more attractive.

Indeed, plenty of investors seem to be giving stocks the cold shoulder. Allocations to U.S. equities fell to an 18-year low while cash allocations crept higher in March, the most recent fund manager survey from BoFA Global Research showed.

Investors will likely remain steeled for another potential high-profile failure until the Fed or Treasury respond in a way that calms fears of another bank run, said Katie Nixon, chief investment officer, wealth management, at Northern Trust (NASDAQ:NTRS), who is focusing on tech-sector stocks with "fortress balance sheets."

"Right now it's a crisis of confidence and everyone is looking for direction," she said.