Business people on a rollercoaster

As banking failures shake markets this week, questions are arising about how widespread the fallout could become.

The risk is that banking sector issues are more widespread than recent bank collapses — beginning with Silicon Valley Bank’s failure last week — suggest.

Invesco strategists wrote in a blogpost on Wednesday that they’ll be watching how the banking sector fares in the face of significant headwinds, especially credit default swaps, to assess the risk of “potential contagion to other large financial institutions.”

A big risk is if tighter monetary policy can’t soon be eased in the face of persistent inflation. Few bank failures (eight) have occurred in the last five years in part because of historically low interest rates, the Invesco blogpost said.

“A prolonged or renewed tightening cycle could increase pressure on the banking sector, increasing recession risks and delaying the time before a sustainable economic recovery could start,” the Invesco strategists said.

In an outlook report on Thursday, Desjardins also noted emerging pressure in the financial system.

“The large spread between deposit rates and money market securities, coupled with quantitative tightening, has created problems in the U.S. regional banking system,” the report said, noting that the Federal Reserve, Federal Deposit Insurance Corporation and U.S. Treasury have taken steps to help alleviate the situation.

“The Federal Reserve will need to carefully balance the tightening in financial conditions stemming from these developments with the threat of persistently high inflation.”

Risk assets are volatile as a result of the uncertain environment, the Desjardins report said, and the firm expects risk assets to trend weaker in the midst of slower economic activity.

Barring further turmoil in the near term, Desjardins’ outlook is for two more quarter-point interest rate hikes stateside before a pause this spring, while the Bank of Canada is expected to hold until it starts easing near year-end.

With fear about banking failures being systemically based as well as monetary policy concerns, investors can expect high market volatility ahead.

In the near term, Invesco said it favours a more defensive portfolio stance: “fixed income over stocks, higher-quality credit over risk credit, as well as defensive sectors and factors.”

However, the Invesco strategists said they expect an improving global risk appetite once the Fed hits pause on interest rates.