Friday's Market Minute: Equity Markets Shrug Off Recent Financial Instability Episodes

Equity markets are inching higher again this week, which is a sign of gradually improving confidence. The S&P 500 bottomed out two weeks ago despite the banking crisis as the tailwind from the market's expectations of the Fed pivot has likely played its part in the recent bottoming process. The bearish consensus on Wall Street has perhaps been blinded by the obsession with the certainty of a recession this year without taking into consideration potential positive outcomes such as anchored inflation expectations and a healthy labor market.

Historically speaking, inverted yield curves tend to signal peaks in the interest rate cycle, with the 2-year Treasury yield rising faster than the 10-year yield and exceeding it during the tail end of monetary policy tightening cycles and the beginning of a recessionary process. Based on recent market performance, underlying relative strength in risk-on sectors’ rotations suggest bullishness.

Sector leadership on a year-to-date basis is clearly not consistent with what we see in advance of a recession, as the technology and consumer cyclical sectors are typically the worst performers and not the best. Healthcare and consumer defensives should be outperforming, but they are lagging overall market performance.

It's clear that risk-on factors have driven equities higher since December's lows. However, equities are nearing a critical juncture as the reward vs risk becomes better balanced. There is the risk of the banking crisis spreading further, tightening lending standards and worsening credit availability. Yet as interest rates fall across the yield curve, the market concerns now appear less focused on the inflation threat and have shifted to assessing the impact of a potential economic downturn.

The tailwind from the market's expectations of the Fed pivot has likely played its part in the recent bottoming process for equities. But at this juncture, lowering interest rates would have a conflicting effect on the Fed's main objectives of curtailing inflation while maintaining financial stability. Therefore, unless the severity of the banking crisis changes for the worse, the Fed is unlikely to pivot anytime soon and the likelihood of another 25-basis point hike in May is still in play.

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