Banking Fallout Adds to Unsettled Markets

Tightening financial conditions are complicating an already uneasy market environment. Hilton assesses current market conditions.

March 21, 2023 5 minute read

Recent failures in the global banking sector coupled with uncertainty surrounding the Federal Open Market Committee’s (Fed) next moves have prompted investors to reprice risk in the capital markets.

Below are some of the key data points the Hilton Capital Investment Committee has been focused on over the past two weeks.

Tightening Financial Conditions Weigh Down Equities

Correlation between financial conditions (as measured by the Bloomberg Financial Index, an indicator of financial stress in the U.S. related to credit access and cost) and the equity market has received heighted attention since the wake of the coronavirus pandemic. At that time, the Fed’s significant quantitative easing drove down capital costs and put money in the hands of consumers which reinvigorated the economy. This drove a significant rally in the equity markets.

Recently, financial conditions have tightened, weighing down the equity market with the prospect of reduced lending and stricter borrowing requirements, both of which would slow growth.

Bloomberg United States Financial Conditions Index & SPX Index
3-21-21 to 3-20-23

Bloomberg United States Financial Conditions Index & SPX Index

Source: Bloomberg Finance, L.P.


Volatility Is Increasing, Especially in Bond Markets

While cross-asset volatility steadily declined during Q422 and Q123, disruption in the banking sector has been met with increased volatility in the markets. While the Merrill Lynch Option Volatility Estimate (MOVE) Index一a measure of the market’s expectations of Treasury bond price volatility over the next 30 days一has been elevated for 12 months, the MOVE recently has reached an all-time high of nearly 200.

Volatility in the equity markets has also trended upward, as investors price in higher levels of risk. This elevated volatility may prove to be a headwind for risk assets, as investors tend to shun risk during times of uncertainty.

Chicago Board Options Exchange (CBOE) Volatility Index (VIX)
Merrill Lynch Option Volatility Estimate (MOVE) Index
Currency Volatility
1-1-21 to 3-20-23

Chicago Board Options Exchange (CBOE) Volatility Index (VIX) Merrill Lynch Option Volatility Estimate (MOVE) Index Currency Volatility

Source: Bloomberg Finance, L.P., Chicago Board Options Exchange, and Bank of America Merrill Lynch.


Treasury Rates Are Trending Lower

Perhaps not surprisingly, rates across the yield curve have seen significant declines. The selloff in rates has been due to a confluence of factors, including a flight to quality assets in the face of increasing economic uncertainty, and a potential Fed policy pivot should inflation slow. The 2-yr rate experienced its biggest weekly drop since 1987. The decline in the 10-yr rate indicates the market is anticipating slower economic growth and concerns of a potential recession has risen.

U.S. Generic Government 2-Yr, 5-Yr, and 10-yr Indexes
12-30-22 to 3-20-23

U.S. Generic Government 2-Yr, 5-Yr, and 10-yr Indexes

Source: Bloomberg Finance, L.P.


Credit Risk Is on the Rise

The fear of broader contagion has predictably impacted credit spreads. After a period of strong relative performance一due largely to investor demand for yield and strong gains in the energy sector一high yield spreads are widening sharply. Currently the U.S. Corporate High Yield Average OAS Index exceeds 500 basis points, its highest level all year.

U.S. Corporate High Yield Average OAS Index
1-1-93 to 3-20-23

U.S. Corporate High Yield Average OAS Index

Source: Bloomberg Finance, L.P.


What’s Ahead From the Fed?

Meanwhile, the Fed’s highly anticipated response later this week remains unclear. Tamping down inflation without pushing the economy into recession was challenging before recent banking sector disruptions. The resulting tightening in financial conditions has made the Fed’s job that much harder.

While a pause in the rate hikes could provide breathing space, it could further delay the taming of inflation. Continued high inflation would cause a variety of issues.

After fighting inflation for the better part of a year, the Fed may be loath to postpone progress. Nonetheless, additional rate hikes could also expose further weakness in the financial system. The Fed now must balance the desire to tame inflation with concerns about systematic stability. Not an enviable task.

Hilton Capital Management’s positioning into this period—defensive—was dictated by macroeconomic concerns visible prior to the recent troubles in the banking sector. The increased turmoil in financial markets does not diminish these concerns but rather heightens them.

As always, we will remain vigilant as conditions unfold.

Hypha HubSpot Development (“Hypha”) and Hilton Capital Management staff (“HCM”) collaborated in the preparation of this article. Hypha is a marketing firm engaged and compensated by HCM. HCM has reviewed and approved this article for distribution. The information set forth in this article should not be construed as personalized investment advice. There is no guarantee that the views and opinions expressed in this article will come to pass. Investing in the markets involves gains and losses and may not be suitable for all investors. The information set forth in this article should not be considered a solicitation to buy or sell any security.

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