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It is time for investors to start making safer bets.
The failure of two U.S. banks and the UBS rescue of Credit Suisse have sent shock waves through financial markets over the past week, raising fears of a bank-lending crunch that could tip economies into recession and derail the Federal Reserve’s efforts to tackle high inflation.
U.S. stocks rallied to start the week on an upbeat note as investors heaved a tentative sigh of relief after U.S. Treasury Secretary Janet Yellen’s reassurances on on the banking crisis on Tuesday helped buoyed market sentiment for now.
However, some Wall Street analysts said it is too early to sound the all clear as investors are still waiting for the “next shoe to drop.”
“We’re not using this [rally] as an opportunity to buy into that and add risk to portfolios… We came into these events already with a more defensive allocation across our portfolios, and we were underweight in equities versus our neutral targets,” said Adam Phillips, managing director of portfolio strategy at EP Wealth Advisors.
“We’re looking at this as an opportunity to actually increase that underweight and shift towards a more defensive allocation across portfolios.”
Taking a strong defensive portfolio is the standard play for investors to cope with most market uncertainties, but a combination of a banking-sector concerns and a potential systemic credit crunch has rattled investors already grappling with rising interest rates and tighter financial conditions.
Some flocked into cash funds as assets held by money-market mutual funds swelled to a record high last week following the collapse of Silicon Valley Bank, but according to Phillips, bonds, after suffering their worst year on record, are again living up to their reputation as the safe part of an investor’s portfolio.
The yield on short-dated U.S. Treasury notes last week plunged to its lowest level in six months on increased safe-haven demand. For the week, the two-year yield dropped a total of 74 basis points, which was the biggest weekly decline since October 1987, a period marked by the Black Monday stock-market crash, according to Dow Jones Market Data.
Meanwhile, U.S. stocks sank last week on worries about the banking system after the sudden meltdown of three U.S. banks – Silvergate Capital
SI,
Signature Bank
SBNY,
and Silicon Valley Bank – began to stoke concerns about weakness in the U.S. banking sector amid sharply higher interest rates.
Equities and bond values do not typically move in tandem. Historically, when the stock prices plunge, investors want to turn to traditionally lower-risk and lower-return investments such as bonds to minimize risks and diversify their portfolios.
However, bond performance is closely tied to interest rates. If interest rates rise, the value of existing bonds will decline as investors no longer prefer the fixed lower rate paid by the bond they are holding, compared to newly issued bonds with higher yields.
That was the case in 2022, when Fed’s aggressive monetary policy tightening cycle precipitated the surge in yields and triggered the heaviest losses in bond markets since at least the 1970s. Stocks, meanwhile, booked their worst annual losses since 2008.
The decoupling of stocks and Treasury bonds indicates that there’s still a reason for owning more intermediate bonds, as bond yields are “offering you an attractive rate of return when you’re worried about the economy starting to slow down,” said Phillips.
“We’d all been positioned for higher rates, when yields were at record lows [last year], and I don’t think many expected it to happen so quickly. We saw yields adjust in what many would maybe expect to occur over a period of several years, but it played out over the course of several months instead,” said Phillips.
He thinks yields were at the most attractive levels at the start of 2023, meaning there’s room for yields to move lower and for prices to go higher, which explains why the correlation between stocks and bonds has been starting to change.
Isaac Poole, global chief investment officer and portfolio manager at Oreana Financial Services, said a prospective credit crunch, triggered by recent stress in the U.S. and European banking system, now makes a U.S. recession more likely than not, and that leaves short-dated government bonds more attractive.
A credit crunch is a significant tightening of lending standards among financial institutions, especially small and medium-size banks, and it happens when they prioritize having a healthy balance sheet over provision of loans. That could make it impossible or costly for businesses to borrow because lenders are scared of bankruptcies or defaults.
“I had been expecting the Fed to pause rate hikes shortly after the March rate hike. The recent developments make that even more likely, given the prospects for growth and inflation. Markets have moved to price a string of rate cuts by year-end, compared with a higher for longer scenario priced in early-March,” said Poole in a Tuesday note.
See: Fed hikes interest rates again, pencils in just one more rate rise this year
The Federal Reserve announced its decision to increase its benchmark interest rate by another 25 basis points to a range of 4.75% to 5% on Wednesday, the highest since October 2007.
Poole said government bonds are the one asset that would do well across a range of scenarios. His portfolios have been adding exposure to shorter-dated U.S. Treasuries, particularly after the 2-year yield edged up above 5% in early March. It then collapsed below 4% last week.
U.S. bond yields plunged Wednesday after the Fed policy makers signaled just one additional interest rate hike will be appropriate this year. The yield on the 2-year Treasury
TMUBMUSD02Y,
declined 19.8 basis points to 3.977% from 4.175% on Tuesday. The yield on the 10-year Treasury
TMUBMUSD10Y,
fell 10.6 basis points to 3.497%.
