Stock market gains despite banking panic. Why the storm will continue.

The volatile trading reflects a crisis of confidence among investors – both about the ability of troubled lenders to withstand customer deposit outflows and about the outlook for the stock market and economy. Strangely, however, the

S&P 500 index

ended the week up 1.4%, while the

Nasdaq composite

were up 4.4% as stocks like Apple (ticker: AAPL) and Microsoft (MSFT) benefited from a flight to safety and falling bond yields boosted growth stocks. Only the

Dow Jones Industrial Average,

which fell 0.15% ended the week lower. It was the first week the Nasdaq rose at least 4% and the Dow fell since 2001.

While not reflected in the main indices, the lingering concern that the intervention of financial regulators on both sides of the Atlantic – and even the banks themselves, after a consortium of financial institutions acted to support First Republic Bank (FRC) – is only a game of Whac-A-Mole, reactive one-off solutions when individual problems arise. There’s still a sense that something is still breaking – and that it might not be so quick and easy to fix.

The turmoil is a result of the transition from the previous era of floor rates and subdued volatility to a higher and more volatile environment. For much of the past decade, long-term, low-yield investments have been in vogue, as long as they offer higher returns than short-term alternatives. But these “carry trades” — the term for borrowing at one short rate to lend at a higher, longer rate — are much harder to sell now that federal funds rates have risen to nearly 5%.

“We think there will be a lot of carry trades under pressure and it won’t be possible to backstop them all,” JP Morgan’s Marko Kolanovic wrote last week. He points to commercial real estate – under fundamental pressure from e-commerce and work-from-home services – as an example of an attractive investment in a zero-rate world whose problems become apparent as rates rise. Cheap financing has also been a huge tailwind for private equity and venture capital business models, which may also come under pressure. Even credit card and auto loans haven’t fully adapted to a world of higher rates, and lenders there can be vulnerable.

“As the economy slows and borrowing costs rise, all of these implied or explicit carry trades are pressured to unwind, leading to the end of the cycle,” Kolanovic wrote.

And that relaxation can be messy for the financial markets. The

Cboe volatility index,

or VIX, jumped to nearly 30 points last week after hovering around 20 for most of the previous three months. The sudden peak has the

Cboe VVIX index

– yes, there is an index of volatility volatility – to levels not seen in a year, after falling to its lowest value in more than seven years in early March. It’s enough to give any investor whiplash, especially since the risks are so hard to quantify and can go in any direction.

“For much of last year, volatility was high, but the risks were somewhat ‘known’ (mainly inflation and recession),” wrote Christopher Jacobson, a strategist at Susquehanna International Group. “Now the introduction of the banking crisis has created a new unknown, which could eventually lead to a stronger increase in volatility (if worse than expected) or a quick recovery (if fears prove unfounded).”

The bond market has been even more volatile. The

ICE BofAML MOVE index

– a VIX for bonds – peaked last week to its second-highest value on record behind only 2008, after doubling from its February low. That is a reflection of the movements in government bond yields, considered the safest and most stable assets, which have been dramatic. The yield on the two-year US Treasury has fallen 1.2 percentage points to 3.85% since March 8, when it was above 5%. That portion of the trade included the largest one-day fall in two-year interest rates since 1982.

The volatility of returns is a symptom of traders trying to obstruct the path of central bank monetary policy from here, something that seems like an impossible task. Just over a week ago, fed-funds rate futures pricing implied an 85% probability that benchmark interest rates would end somewhere between 5.25% and 6% in 2023, versus the current target range of 4.5% to 4.75 %. Today, the odds imply a year-end fed-funds rate between 2.75% and 3.25%. Expectations have quickly shifted to a lower and approaching peak and more cuts in the second half of the year.

As for the Federal Open Market Committee’s decision next Wednesday, the biggest odds implied by the futures markets tend to be up 0.25 percentage points, with about a one-third chance of no change. Before the crisis of confidence, the debate was about whether to raise the FOMC by a quarter or a half point.

The latest inflation and other economic data argue for an increase, while the bank blowouts suggest a pause may be wise. What officials ultimately decide to do will depend on what happens between now and then. “If tensions continue, more banking issues come into view, etc., they are off,” wrote RBC Capital Markets Chief US Economist Tom Porcelli. “When things settle down a bit, they go away. That’s the decision tree for the Fed. In many ways it will be a match decision for them.”

Expect the market storm to continue.

Write to Nicholas Jasinski at nicholas.jasinski@barrons.com