Stocks will tumble if the Fed pauses rate hikes because it would mean other banks are about to collapse, DataTrek Research says

• Following the failure of SVB, some commentators predicted a pause in Fed rate hikes.
• But DataTrek expects as much as a 5% sell-off in stocks if the Fed doesn't raise rates this month.

The stock market could see a sell-off if the Federal Reserve decides against an interest rate hike at the March meeting, as it would suggest more banks are teetering, according to DataTrek Research.

Before Silicon Valley Bank failed last week, markets widely expected a Fed rate hike of 25 or even 50 basis points this month. Fed officials also signaled more increases were coming.

Now the odds that the Fed holds rates steady are 43%, while the odds of a quarter-point increase are 57%, according to CME's FedWatch Tool.

Should a pause happen at next week's Fed meeting, DataTrek cofounder Nicholas Colas said global equities would likely tumble by 3% to 5%.

"If the Fed suddenly paused its long-promised rate hiking cycle, it would be a sign that they knew other US regional banks were on the precipice of failure," he wrote in a Wednesday note.

For the Fed to pause rate hikes due to bank failure concerns would be easing for the wrong reasons, Colas added.

"As much as equities want to see Fed Funds stabilize, they want this to happen for the 'right' reason: the Fed growing convinced that inflation is under control and on a glide path to 2 percent," he wrote. "A sudden raft of bank failures or even a dramatic contraction in bank lending due to systemic uncertainty is definitely a very "wrong" reason to pause rate hikes."

On Tuesday, Moody's cut its outlook on the entire US banking system, days after regulators shut down Silicon Valley Bank and Signature Bank, and shortly after Silvergate shut down voluntarily.

The ratings agency cited the rapid deterioration of the financial landscape, given the bank runs and government intervention.

"Our base case is for the Fed's monetary tightening to continue, which could deepen some banks' challenges. Further drivers of the outlook are detailed in the overview table and bullets that follow," Moody's said.