The failure of Silicon Valley Bank has torn into global markets, with investors ripping up their forecasts for further rises in interest rates and dumping bank stocks around the world.

Government bond prices soared on Monday, with two-year US Treasury yields recording their biggest one-day drop since the financial crisis of 2008, as fund managers ramped up bets that the US Federal Reserve would leave interest rates unchanged at its next scheduled monetary policy meeting this month to steady the global financial system. As recently as last week, markets were braced for another half-percentage point rise.

In the US, the two-year Treasury yield, which moves with interest rate expectations, fell by 0.41 percentage points to 4.18 per cent. It had earlier slipped below 4 per cent to its lowest level since September. The benchmark 10-year government bond yield slipped 0.22 percentage points to 3.47 per cent.

SVB was taken over by regulators last week after customers raced to withdraw their money in the biggest test of the US financial system since 2008. On Monday, US president Joe Biden sought to reassure Americans that their money is safe, vowing to do “whatever is needed” to protect bank deposits. The Bank of England brokered a deal to sell the UK arm of SVB to HSBC for £1.

Still, bank stocks dropped heavily as investors fretted over which other institutions might also come under strain.

In the US, shares in First Republic dropped 77 per cent, and were halted 15 times in the first two-and-a-half hours of trading despite the San Francisco-based bank telling investors it had $70bn in unused liquidity.

The KBW banks index, which includes larger lenders, fell 11 per cent, even while the benchmark S&P 500 index of the country’s biggest stocks was trading 0.5 per cent higher.

Europe’s Stoxx banks index fell 6.5 per cent, taking its decline since the middle of last week to just over 11 per cent, with all 22 stocks in the index in negative territory. Several lenders suffered double-digit declines on Monday alone, including Spain’s Banco Sabadell and Germany’s Commerzbank. Austria’s Bawag Group fell 8 per cent.

The failure of SVB and closure of Signature Bank come just months after the shortlived crisis in UK government bonds, underlining the risks buried in the financial system as central banks rapidly lift borrowing costs. Investors and analysts said policymakers would need to tread carefully as they sought to hose down inflation.

“The SVB situation is a reminder that Fed hikes are having an effect, even if the economy has held up so far,” said Mark Haefele, chief investment officer at UBS Global Wealth Management, in a note to clients. “Concerns over bank earnings and balance sheets also add to the negative sentiment for . . . equity markets.”

Investors believe recent developments mean the Fed will ease off its campaign to raise interest rates, after weeks of debate over whether it will opt for a 0.5 or 0.25 percentage point increase after its meeting later this month.

Refinitiv data now shows traders see a roughly even split between the odds of a quarter-point rise and the Fed leaving rates unchanged.

Goldman Sachs said on Monday that it no longer expected any increase at the Fed’s meeting ending on March 22 “in light of recent stress in the banking system”.

The shake-up in bond markets was substantial. Germany’s interest rate-sensitive two-year bond yield plummeted 0.38 percentage points to 2.68 per cent on Monday, as bond markets rallied sharply in response to fading expectations of further increases in borrowing costs. The rate has fallen from the 14-year high of 3.3 per cent it hit last week, showing how sharply investors have repriced their rate expectations since SVB’s collapse.

Greg Peters, co-chief investment officer at PGIM Fixed Income, said he believed the rally in government bonds was misplaced. “It’s way too big of a move. The markets are overreacting massively; they completely forgot about inflation,” he said. “This is a massive head fake.”

But some investors and analysts, including George Saravelos, a strategist at Deutsche Bank, said the SVB rescue package from the Fed, which includes an offer to absorb government debt and mortgage-backed bonds at above-market prices, represented a new form of quantitative easing — the waves of bond-buying used by policymakers to stabilise the financial system over the past decade and a half.

“Both the speed and end point of the Fed hiking cycle should come down,” Saravelos said, adding that tightening would now be “amplified due to stress in the US banking system”.

Michael Every, an analyst at Rabobank, said the implications of the Fed’s “bailout of Silicon Valley venture capitalists funding Instagram filters that make cats look like dogs” were potentially “enormous”.

“The Fed is de facto allowing a massive easing of financial conditions as well as soaring moral hazard,” he said in a note to clients.

Currencies that perform well in times of stress also rallied. The Japanese yen and the Swiss franc both climbed more than 1 per cent against the dollar.

The rapid collapse of SVB made market participants “more aware again that the Fed will eventually break something if it keeps raising rates”, said Lee Hardman, currency analyst at MUFG.

The bank’s collapse had also “taken the wind out the US dollar’s sails” by highlighting risks associated with rising rates, Hardman added. A measure of the dollar’s strength against a basket of six international peers fell 1.0 per cent on Monday.

Additional reporting by Martin Arnold in Frankfurt