What’s at stake for stocks, bonds as Federal Reserve weighs bank chaos against inflation fight

Markets may be in a vulnerable position ahead of the Federal Reserve’s meeting this week, as traders bet the banking crisis could lead to meaningful interest-rate cuts over the next year.

But in his view, the Fed’s emergency measures helped stabilize the financial system, giving it room “to go and fight the inflation that remains too high in the economy.” “If you’re going to protect the depositors and let the stock and bond holders take the hit that they justly deserve,” he said, “that’s fine.” Describing himself as “a practical libertarian,” Arnott said “I’m totally on board with saving two or three mid-sized banks in order to prevent contagion.”

While inflation has come down this year, it remains high, and Arnott anticipates it may wind up being stickier in the second half of 2023 when year-over-year comparisons become more difficult. As a result, the rate of inflation could end the year in the range of 5% to 6%, he estimated. Now it’s “a complicated situation” because of financial stability concerns, said Sonders. She said she expects lending conditions will continue to tighten in the wake of the Fed’s aggressive rate increases over the past year and recent bank woes.

Yet to Elliott, the U.S. appears “at least as far away from recession” as it was three or six months ago. And based on the 100 basis points of “easing” he saw priced in the market over the next 12 months, he said even a pause in the current tightening process could lead to a selloff in bonds and likely be “a drag on the stock market.”

While stocks and bonds were hurt by rising rates last year, Phil Camporeale, a portfolio manager at JPMorgan Chase & Co., told MarketWatch that he’s recently seen fixed income play a defensive role in the tumult from the banking sector.

It will be interesting to see how the Federal Reserve's decision impacts the stock and bond markets.

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