Analysis-Banking Woes, Fed Keep Investors On Edge In Nervous U.S. Stock Market

Investors are settling in for a long slog in the U.S. stock market in coming months, braced for more tumult in the banking sector and worries over how the Federal Reserve's tightening will ripple through the economy.

Banking sector concerns drove sharp moves in financial stocks in the United States 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.

Many worry that other nasty surprises are lurking 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.

"The market is very nervous at this point and investors are acting first and looking into the nuances later," said Wei Li, global chief investment strategist at fund giant BlackRock. "It's understandable because it's not super clear that this is definitely contained."

In recent days, investors have focused on German giant Deutsche Bank. The company's 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 analysts said in a Friday report.

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 of large financial institutions. But investors are guarded, wary that another bank run could erupt if people believe U.S. or European regulators won't protect depositors.

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

Uncertainty over the Fed's intentions is amplifying investors' hesitation in stocks and sparking huge swings in U.S. government bond prices.

The Fed raised rates by 25 basis points on Wednesday but indicated it was on the verge of pausing further increases. Investors piled into the safe haven of U.S. Treasuries, sending yields on the two-year note, which closely reflects Fed policy expectations, to 3.76% this week, the lowest since mid-September.

Further banking industry failures could mean sooner rate cuts 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. "It makes sense to take risk in those areas to take advantage of the weakness we're seeing now."

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.

Investors will likely remain steeled for the potential for another 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, 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.