When the Fed hits the brakes, someone goes through the windshield, states Steve Reitmeister of Reitmeister Total Return.

This classic investor saying is a great one to contemplate today. It certainly was true back in 2008 as rates were soaring higher leading to the onset of the financial crisis followed by the Great Recession. It was also true in 1999 when Greenspan wanted to wipe out irrational exuberance with a flurry of rate hikes leading to a three-year bear market.

And now the Fed's most recent hawkish regime has sent rumblings across the banking sector that have led to tremendous market volatility. Let's dig deeper into this vital topic and what it means for our market outlook and trading plan.

Market Commentary

I am going to pass the baton to John Mauldin to start off today’s conversation. That is because he always does a wonderful job explaining complicated situations in the clearest possible landing. I think this top section gives the core of what you need to know:

“For years I’ve used a sandpile metaphor to describe complex systems like banking. Keep dropping grains of the sand long enough and you will eventually trigger an avalanche.

“Eventually” is the key word. Exactly which grain will do it, you can’t know.

But before the collapse, the sand grains accumulate to a larger and larger pile. They form “fingers of instability”—small weaknesses where a larger failure could begin. Sooner or later, one will break but no one knows when. Will it cause a small avalanche or “the big one?”

These unstable fingers seem to be piling up lately. Last October, the UK had a brief bond crisis when some budgetary changes revealed rather questionable pension fund activities. Then the bankruptcy of crypto exchange FTX showed how supposedly “trustless” assets can require a lot of trust.

In just the last week we’ve seen the second-and third-largest bank failures in US history: Silicon Valley Bank and Signature Bank. Several others look shaky. Authorities responded swiftly (and I think correctly) to stabilize these situations. I see no need to exit 99% of banks, but everyone should definitely pay attention to make sure your bank is not in the 1%. Important things are happening.

In short, this isn’t 2008. But it’s also not nothing.”

Read that last line again as that is the crux of the matter. Meaning real damage has already been done and likely more pain is on the way. Some of that pain will come in the form of additional bank failures as investors and regulators turn over every rock to ensure the system is running smoothly. No doubt they will uncover other bad apples that need to get cored.

The future pain will also come in other forms as I shared in my weekend article. Here are key sections from that commentary:

“Unfortunately enough damage has already been done that even if another banking failure does not emerge, it already puts a thumb on the scale towards recession. Don’t just take my word for it...let’s get some insights from one of the economists over at JP Morgan who recently said:

“A very rough estimate is that slower loan growth by mid-size banks could subtract a half to a full percentage point off the level of GDP over the next year or two. We believe this is broadly consistent with our view that tighter monetary policy will push the US into recession later this year.”

Goldman Sachs had similar sentiments in a note this week:

“We have seen a tightening of lending standards in the banking system, and my suspicion is that they will tighten further from here and potentially could tighten quite sharply, at least in the near term. On balance, my guess is that banks will take a view that this could result in either a near-term recession or a deeper recession than you would have had without this event.”

This is probably the best-case scenario.

Now imagine the worst case. That being greater scrutiny by investors and bank regulators which uncovers another handful or more of large banks that need to be taken over or recapitalized. The headline risk on each round of breaking news would be bad and devastating for the stock market.

Beyond that is the increase in fear by the average consumer and business owner that leads to greater caution...which is a fancy way of saying they will spend less. That is the road to recession. And that road was already paved by the Fed with a hawkish regime dead set on lowering demand to tame inflation this year.

I cannot say for sure where on this spectrum of banking outcomes we will land. Unfortunately, even the best case for banks still points to likely recession and extension of a bear market.”

In a nutshell, landmines have already been placed out there in the economic landscape. How many will be stepped on, and the total amount of damage, is yet to be determined...but no doubt that damage is much greater than none.

Now let’s turn the page to the next big event...that being the Fed rate hike announcement on Wednesday 3/22. Most investors are pretty well settled on them maintaining the 25-point hike pace of the last couple of meetings. So, the real key to any change in the language given the recent banking issues. This is a tightrope walk for sure. Their main goal is to calm nerves. However, it is easy to sway too far in that direction, actually making investors fearful. Meaning if the Fed seems too concerned with the banks...then it will only increase the fear that there are more bombs to go off in the financial sector. Selling would be violent on that notion.

Probably the worst potential outcome would be for them to pause rate hikes for the improved stability of the financial system. Yes, many people would like to see the Fed stopping the rate hikes because inflation is getting under control...but not for this reason. This move would be a red flag that would also lead to a massive sell-off. Note that the market reactions immediately after the Fed statements are confusing, to say the least. Often traders jump to shortsighted conclusions leading to dramatic 180-degree reversals in the days that follow as investors really think through the long-term ramifications. Meaning, best to think through your next steps and not get caught up in the FOMO.

There were plenty of reasons to be bearish before the banking concerns came on the scene. But since this group is really the first through the windshield...then it only adds more fuel to the future recessionary fire. That is why I continue to bank on more stock market downside ahead.

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