This signal for U.S. stocks bodes well for a rally as some stability returns to the banking sector

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The U.S. stock market has been flashing an important signal that suggests concerns about the banking sector have dissipated after the sudden collapse of Silicon Valley Bank earlier in March.

The Cboe Volatility Index
a gauge of expected volatility in the S&P 500 index, dropped below the 20 level last week for the first time since March 8, suggesting a return to a lower risk environment that prevailed before Silicon Valley Bank first announced it had to sell securities to strengthen its deteriorating financial position.

The index, often referred to as Wall Street’s “fear gauge,” was down 1.7% at 18.70 on Friday after rising above 30 on March 13, the first trading day after regulators announced emergency measures to stem fallout from Silicon Valley Bank’s failure.

“It’s not a normal volatility environment,” said Johan Grahn, head ETF market strategist at AllianzIM. “We’ve spent 95% of trading days in the past 12 months above 20, while we were above 20 only 15% of the time in the 8-year period before the pandemic-driven volatility started in February of 2020.”

He also noted the VIX topped 30 in one of five days over the past 12 months on average, but only one in 100 days over the same 8-year period before the pandemic. 

“Now we’re living in those periods as if it’s normal, but it’s not normal based on that history,” Grahn said. 

Other market analysts also said investors should beware of what comes next.

Interest rate cuts in 2023 could signal a tanking economy

The three major U.S. stock indexes ended the month on a positive note with the S&P 500
gaining 3.5% and the Dow Jones Industrial Average
up 1.9%, according to Dow Jones Market Data. The Nasdaq Composite
advanced 6.7% as volatility in banking-sector stocks ignited a rush into the technology sector.

See: Are tech stocks becoming a haven again? ‘It’s a mistake,’ say market analysts.

For the quarter, the Nasdaq Composite rose 16.8%, its best quarterly gain since at least the fourth quarter of 2020, according to Dow Jones Market Data. The S&P 500, meanwhile, rose 7%, and the Dow advanced 0.4% in the first three months of 2023.

“Those worst fears have been taken off the table, at least for the time being. I think you’re just seeing a reflection in the markets of that fact,” Grahn told MarketWatch via phone.

“Fed Chairman Jerome Powell came out and started flexing his dovish wings a little bit by taking the banking issues into consideration and now leading the market to believe that maybe he will slow down what previously was communicated as more aggressive rate increases,” he said.

Stress in the banking sector and a possible credit squeeze has led markets to reprice expectations of future monetary tightening by the Federal Reserve. Traders’ bets are tilted toward a pause in interest rate increases in May, with odds of a 25-basis-point increase at 49%, according to CME FedWatch tool.

However, Grahn thinks if investors expect rate cuts will happen later this year, that could suggest the economy will tank “very soon” and in a “very painful way.”

Investors are effectively saying “there will be so much pain coming through the system so that the Fed cannot make an argument that holds water for why they want to keep the rates high,” said Grahn. “The risk sensitivity between what the market is pricing in terms of rate increases and where the Fed is telling the market that they’re going to be is way too wide. And the way that the market can be right is if we have a disastrous couple of months ahead of us.” 

See: 2023 has been bad for the bears. Here are 5 reasons why it’s going to get even worse.

Liquidity spigot, back on

David Waddell, CEO and chief investment strategist at Waddell & Associates, said it has been past bailout reassurances that have stabilized financial markets, because they neutralize the threat of banking stress.

“Once the Fed turned on the ‘liquidity spigot’ and softened their rhetoric, the market took off, because while crises may destroy investor capital, bailouts create even more,” Waddell told MarketWatch in a phone interview.

It also bolsters the case for a shallow recession, he said, because the Fed has shown a tendency to over medicate. “The ‘patient’ will be fine,” Waddell said.

After Silicon Valley Bank failed earlier this month, U.S. Treasury Secretary Janet Yellen ruled out a return to broadscale federal bailouts for banks and emphasized the situation was very different from the 2008 financial crisis, which resulted in unprecedented measures to rescue the nation’s biggest banks. 

See: Two-year Treasury yields sees biggest monthly drop since 2008 after bank turmoil

Big moves in Treasurys

U.S. Treasury yields tumbled in March with two-year rates
posting their biggest monthly yield drop since January 2008. The yield on the two-year Treasury note traded at 4.06% on Friday, down 73.5 basis points in March, according to Dow Jones Market Data.

“So far, equities are holding up and economic data has not materially faltered, but I can say with confidence that moves of this magnitude in the Treasury market are not typically signals of smooth sailing ahead,” said Liz Young, head of investment strategy at SoFi.

The ICE BofA MOVE Index, which measures the implied volatility of the U.S. Treasury markets rallied to 198.71 in mid-March, its highest level since 2008, according to FactSet data. 

“At the very least, they’re indicating that the uncertainty around Fed policy has risen. Not only due to the recent fears in the banking system — but to the unclear end to the Fed’s hiking cycle.” 

Earnings reports, March jobs data ahead

Waddell said investors shouldn’t rely too heavily on a few week’s gains in U.S. stocks, but thinks market sentiment could improve in April due to surprise in the “resilience of earnings and the robustness of them in the recovery.” 

However, John Butters, senior earnings analyst at FactSet, said there has been larger cuts than average to EPS estimates for S&P 500 companies for the first quarter of 2023, given the continuing concerns in the market about bank liquidity and a possible broader economic recession.

The estimated earnings decline for the index is 6.6% for the quarter. If that is the actual decline, it will mark the largest earnings decline reported by the index since the second quarter of 2020, Butters said in a Friday note. 

Several Federal Reserve speakers are on deck for next week, but the other big thing to watch will be the monthly jobs report for March from the U.S. Labor Department on Friday.

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