Why the implosion of Silicon Valley Bank is actually a good thing for stocks

• The implosion of SVB makes for scary headlines, but it could actually be great for the stock market.
• That's because the event could trigger a reversal of the primary cause of the stock market's pain in 2022: rate hikes.
• Interest rates plunged on Monday, and expectations are growing that the Fed will pause its aggressive hikes. 

The implosions of Silicon Valley Bank, Silvergate Capital, and Signature Bank in recent days might make for scary headlines. But they could actually be bullish developments for stock investors.

That's because the Federal Reserve may be forced to slow the pace of rate hikes it's been enacting since March 2022. It would be welcome news for investors who have felt the pain of tighter financial conditions as stocks have limped to a weak start this year.

It would also help alleviate the very pressure that led to the collapse of these institutions. After all, the rising-interest-rate environment is what put the firms in such a precarious situation to begin with, as risk-free government bonds started yielding more than their debt. Customers pulled money and fled to greener pastures, and the panicked situation eventually snowballed into a series of bank runs.

Now, with the prospect of further rate hikes diminished, investors are scrambling to reassess what it means for two main drivers of stock gains: corporate earnings growth and risk appetite. Based on Monday's market action, it's positive: all three US indexes rose, with the more rate-sensitive Nasdaq pacing the gains with a 1.4% increase.

A number of Wall Street firms have already forecasted a pause in rate hikes, Goldman Sachs chief among them.

"In light of recent stress in the banking system, we no longer expect the FOMC to deliver a rate hike at its March 22 meeting with considerable uncertainty about the path beyond March," the firm's chief global economist Jan Hatzius said in a note to clients.

That's a big deal. Just last week stocks sold off as Fed Chairman Jerome Powell presented a hawkish stance to Congress, leading the market to expect a 50-basis-point hike next week, followed by at least a couple more later in the year.

Now some are seeing the fragility in the regional banking sector, and market expectations have started to lean towards something previously unthinkable: rate cuts later this year. That would be rocket fuel for stocks.

A reversal in a key market dynamic

Fast-rising interest rates throughout 2022 dinged company valuations and sent the broader stock market into a bear market. Now the exact opposite dynamic is now at play. The 2-Year US Treasury yield plunged more than 40 basis points on Monday, and has fallen nearly 90 basis points since late last week. Stocks suddenly look more enticing relative to the risk-free bonds that have dented their appeal.

As long as the Fed doesn't continue with its hikes, the momentum to the upside in rates may have been finally broken, meaning lower interest rates are a possibility.

"Based on the financial market turbulence over the weekend, and signs of a sudden intensification of risk aversion, we now believe that a 50 basis point hike is off the table for next week and that the decision point will be between a 25 basis point hike or a pause," Barclay's said in a Monday note. "Although we cannot rule out the first scenario, we believe that the most likely outcome will be a pause."

There's historical precedent for what investors are predicting. Some have pointed to the 1994 bankruptcy of Orange County as an event with parallels to today's interest rate environment.

In 1994, the Fed aggressively hiked interest rates to slowdown the economy, raising its benchmark rate from about 3% to 6%. The sharp upwards move contributed to the bankruptcy of Orange County, and the Fed's next decisions were to pause, and then to ultimately cut interest rates in the summer of 1995.

The stock market performed remarkably well in the following years. If the Fed has the same fears that it may have broken something, and decides to tread carefully around further rate hikes, the stock market could be poised for a similar bullish reaction.