This morning, more bad news on the bank front is causing money markets to sharply reset downward their expectations for interest rates later this year. This kind of panic is typical of the “shoot first, ask questions later” behavior seen during times of high financial anxiety. In my view, investors are getting ahead of themselves. While the possibility of an all-out financial crisis should not be dismissed out-of-hand, we are more likely looking at a slow unwinding of years of artificially low interest rates that will cause serial but not catastrophic dislocations. The Fed is unlikely to change course as markets are starting to price in.

This morning, S&P downgraded First Republic Bank (FRC) to “junk” status (BB+ from A-) which spells big trouble for the bank. It is virtually impossible for any bank to operate with a below investment grade rating since such a rating drives it funding costs too high to render it profitable. This could well force a sale of FRC to a stronger institution.

Also this morning, the already decimated stock of Credit Suisse Group AG (CS) fell another 24% when the Saudi National Bank, which owns 9.9% of the bank and recently invested $1.5 billion of the $4 billion capital raised to support the bank’s “restructuring” (a polite word for a management overhaul which it doesn’t appear to have gotten), said it won’t increase its stake. This took down the rest of the European banking sector with it (for some reason, The Wall Street Journal’s Heard on the Street column ran a column this morning recommending European bank shares which is taking contrarian thinking too far). At this point, it looks like the European Central Bank and Switzerland are going to have to backstop depositors to prevent a wholesale banking crisis. As noted yesterday, CS has more than US $500 billion of assets and is interconnected with the global financial system in all kinds of ways that SIBV was not; its collapse would be a systemic event (not in a good way obviously).

As a result of all of this happy news, U.S. Treasury yields are collapsing and market expectations for further Fed tightening are vaporizing. For the moment, the market is pricing in 120 basis points of rate cuts later this year which - absent an all-out crisis - seems like panic rather than a reasoned position. More reasonably perhaps, it is now pricing in a 60% chance of a pause in interest rate hikes though I still expect a 25-basis point hike this month (barring any further catastrophic news before the meeting). But it is going to be a close call as the Fed chooses between stabilizing the banking system and fighting inflation which continues to run hot.

Even as they get hammered this week, stocks are trading at much higher valuations than justified by the financial environment. All the talk about looking for opportunities in the markets strikes me as extremely imprudent. Investors should be protecting their capital, not risking it in a market facing genuine systemic risk. If the Fed does reverse course, which in my view will only happen only in a crisis scenario, it will leave inflation as a huge problem eroding the value of all financial assets. And if the Fed were to abandon the inflation fight, even temporarily, it would signal deep concern about systemic stability that hardly suggests buying stocks is a good idea. Better to let the storm pass before risking capital. There is no need to take losses trying to be a hero. Investing is much easier if you are not trying to dig yourself out of a hole. Just ask the Fed.