Why US Stocks Rallied Last Week Despite the Banking Crisis?

Bullion Bite

The US stock market rallied last week despite concerns over the failure of major banks and the risk of a credit crunch. The reason for the rally is not entirely clear, but some clients believe that the bailout of depositors by the Fed and FDIC is a form of quantitative easing (QE) that will provide a catalyst for stocks to go higher. However, the increase in Fed balance sheet reserves does little to create new money that can flow into the economy or the markets beyond a brief period. Furthermore, the fact that the Fed is lending, not buying, makes a difference in terms of creating balance sheet space for renewed expansion. Moody's recent downgrade of the entire sector will likely contribute further to the deceleration of the overall velocity of money in the banking system.

Bond markets have exhibited extreme volatility around these developments as market participants realize the ramifications of tighter credit. The yield curve has bull steepened by 60bp in a matter of days, something seen only a few times in history and usually the bond market’s way of saying recession risk is now more elevated. An inversion of the curve typically signals a recession within 12 months, but the real risk starts when it re-steepens from the trough. Meanwhile, the ECB decided to raise rates by 50bp last week despite Europe's own banking crisis and very sluggish economy.

From an equity market perspective, the events of the past week mean that credit availability is decreasing for a wide swath of the economy, which may be the catalyst that finally convinces market participants the equity risk premium (ERP) is way too low. The correlation between stocks and bonds has reversed and is now negative, indicating that stocks go down when rates fall and vice versa. This is in sharp contrast to most of the past year when stocks were more worried about inflation, the Fed’s reaction to it, and rates going higher. Instead, the path of stocks is now about growth, and the belief that earnings forecasts are 15-20% too high has increased. With the acknowledgment of a low equity risk premium comes the real buying opportunity.

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