Why Investors Still Need to be Cautious About the Banking Sector

From the looks of things, the market appears ready to move on from the banking sector crisis that rattled Wall Street to the core just several days ago. With troubled regional banks moving up sharply during the Tuesday session, the worst seems to be behind us. As further confirmation, the benchmark S&P 500 index popped up more than 1%. Still, investors should not yet abandon the cautionary approach.

To be clear, I’m not suggesting that market participants panic. Even if the global markets were to melt down, reacting frantically and emotionally to events you can’t control wouldn’t be productive, to say the least. However, it may not be prudent to abandon all vigilance and assume that circumstances will be completely normal from here on out without suffering some consequences.

What concerns me is that Wall Street may be a bit too optimistic for its own good. As Barchart contributor Rich Asplund noted, stocks rallied on the March 21 session as fears associated with the banking sector fallout subsided. Capital-boosting arrangements and other deals helped reinforce confidence in the beleaguered arena.

As well, Treasury Secretary Janet Yellen stated that “our intervention was necessary to protect the broader U.S. banking system, and similar actions could be warranted if smaller institutions suffer deposit runs that pose the risk of contagion.” So, the message is clear: if fiscal waste matter hits the proverbial fan, Uncle Sam stands ready to undergird the financial ecosystem.

Still, over the long run, that’s not really the message astute investors want to hear.

No Ammo in the Tank

Fundamentally, what bothers me about the government’s reassurances about injecting stability if necessary is that none of its actions occur in a microcosm. Instead, anything that impacts the value of the U.S. dollar – the world’s reserve currency – will ripple throughout the global economy. Therefore, irrespective of whether we’re talking about appropriate or misguided intervention, it’s the intervention itself that may be the problem.

Put another way, people generally tend to avoid surgery if less invasive or onerous alternatives exist. Mainly, no surgical procedure can be 100% guaranteed to yield positive outcomes without side effects or longer-term consequences. Either way, it’s a serious decision to override the human body’s natural healing mechanisms. So it is with meddling with the principles of free market capitalism.

More importantly, it’s probably not possible to perpetually modulate borrowing costs without breaking more cogs in the flywheel. With the Federal Reserve sparking massive liquidity to address the disruption of the COVID-19 crisis, it may lack the ammunition needed to constantly steer the economy away from one crisis after another.

Banking Sector Fallout Imposes a Distraction

One of the most problematic elements of the implosions suffered by the banking sector is that it represents a major distraction to the Fed. After all, the whole point of the hawkish pivot in monetary policy was to control inflation. Indeed, during Fed Chair Jerome Powell’s speech at Jackson Hole, Wyoming last year, he emphasized the need to take action now to avoid harsher consequences later.

“While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain,” Powell said in part.

However, the banking sector fallout disrupts this directive. Further, if the government were to step in to mitigate future deposit runs, that would imply an accommodative (inflationary) response. That’s exactly what Powell stated he wanted to avoid.

Now, the Fed finds itself in a bind that it can’t easily slip away from.

The Losses Are Still Severe

Much has been made of the dramatic rise in previously embattled bank stocks, perhaps most notably First Republic (FRC). On Tuesday, FRC stock jumped over 29%. On paper and without broader context, you’d be forgiven for thinking that the federal government managed to do something perfectly kosher for a change.

However, despite the cash injection that First Republic secured, the enterprise remains deeply troubled. We’re talking about a publicly traded security that in the past five sessions is still down more than 53%. And in the trailing month, FRC gave up 87% of equity value. That’s not something that can be overcome with merely a modest application of effort.

In other words, it’s good to celebrate a home run in the second inning. But you shouldn’t lose your composure so early in the game. There’s still a lot of baseball to be played.

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