It was widely understood that the Federal Reserve would raise rates until one of three things took place: inflation was clearly on course to return to the target, the labor market would weaken precipitously, or systemic stress threatened. At the same time, the shocks we have had to cope with: Covid, supply chains, and Russia's invasion of Ukraine were commonly cited, and the re-pricing of assets as interest rates began normalizing may have been under-appreciated. In addition, stress was seen in household debt delinquency figures like auto loans. It was also recognized that banks had not passed the higher interest rates to depositors and that money markets and T-bills were attracting funds.
The weak link was discovered, and it was again, like the Great Financial Crisis, rooted in the US. It is the first test of the post-Dodd Frank regulatory era and was found wanting. A new repo facility has been announced, and the FDIC invoked its "systemic risk" clause and covered the uninsured depositors. While there are moral hazard concerns, the urgent matter was to contain the bank run. One of the costs investors suspect is an adverse impact on central bank efforts to reinstate price stability. Yet the financial shock is understood to be deflationary.
Moreover, it is not just a US development. Banks in Europe and Japan also feasted on high-priced (low-yielding) government bonds, and there were pre-existing conditions (that were brought to a head at Credit Suisse). Still, say what one will about the supposed G-zero world or alternative payment systems, and even the supposed Petro-yuan, but in finance, the world is still one in which when the US sneezes, others are vulnerable to pneumonia. An index of EMU banks fell 13.4% last week following a 5.1% loss in the previous week. The KBW index of US banks fell 14.5% last week after falling 15.7% the week before the Federal Reserve, FDIC, and the US Treasury took action.
United States: The market has thought it heard Fed Chair Powell endorse a 50 bp hike in testimony to Congress in early March. The talk was a Fed funds target of 5.75%, if not higher. Post-SVB and the emergency measures, the market has concluded that even a 25 bp hike is not a done deal. It is not quite for the reasons we thought, but the Fed funds futures market has unwound the changes spurred by the robust jobs data reported in early February, the hawkish signals from some Fed officials, and more. A cut is priced into the futures strip by the end of Q3. There is no meeting in January 2024, so the implied yield of the January contract of around 4.10%, down from about 5.55% as recently as March 9, is a fair representation of the expectation for the year-end rate. The upper end of the current target range is 4.75%.
The FOMC meeting ending March 22, which will update the Summary of Economic Projections (dot plot), and the seeming fragility of the financial system, overshadows the high-frequency data reports in the week ahead. These include new and existing home sales, durable goods orders, and March surveys (preliminary PMI and non-manufacturing surveys from Philadelphia and Kansas). The dramatic swing in market views, driven by its understanding of the Federal Reserve's reaction function, poses new challenges for the conduction of monetary policy, especially given Powell's recent economic assessment. The dramatic $300 bln expansion of the Fed's balance sheet unwinds the quantitative tightening seen over the past year. Still, not all balance sheet expansion is QE, and some market participants have difficulty distinguishing between the two. Meanwhile, there has been a sharp decline in inflation expectations. The two-year breakeven (difference between the conventional yield and the inflation-protected security) has fallen from 3.40% on March 6 to around 2.60%. The 10-year breakeven fell from nearly 2.55% on March 3 to about 2.15% ahead of the weekend.
The Dollar Index's range in the middle of last week (~103.45-105.10) may be key to the near-term direction. The 105.00 offers resistance, and the 103.50 area support. Our bias is lower, but the elevated fears that the crisis has yet to be adequately ringfenced offer the greenback some safe-haven appeal. The five-day moving average has crossed below the 20-day moving average for the first time since early February, illustrating the loss of momentum. We favor a downside break, and a loss of support could initially spur a move toward 102.50-75.
United Kingdom: The February inflation figures will be reported two days before the Bank of England meeting on March 23. The pace of the year-over-year slowing is likely to accelerate. In February, March, and April, CPI rose by 0.8%, 1.1%, and 2.5%, respectively. These will drop out of the year-over-year measures and send the headline rate toward almost 6% by the end of April from 10.1% in January, making a conservative assumption that the six-month average of 0.5% is maintained rather than something closer to the three-month average of 0.1%. On March 6, the swaps market was sure that the BOE would hike the base by 25 bp, but the pendulum of market sentiment has swung. The market now sees about a 45% chance of a hike. The base rate is 4.00%, and the terminal rate expectation was between 4.75% and 5.0%. It is now between 4.00% and 4.25%. Retail sales and the preliminary PMI are released at the end of the week and will help gauge an economy that is somewhat more resilient than many had expected.
Sterling extended its recovery from the year's low set on March 8 near $1.18. It pushed above $1.22 early last week before consolidating. During that consolidation, it held above $1.20 and finished the week firm, near $1.2170. Sterling's five-day moving average has crossed above the 20-day moving average for the first time since early February, but in the bigger scheme, it continues to seem broadly range-bound. The mid-February high was set near $1.2270, which has to be taken out to signal a move to retest the high set in mid-December and again in January and early February near $1.2450.
Japan: The drop in global interest rates benefits the incoming Bank of Japan governor, Ueda. The 10-year JGB yield pulled back well below the 0.50% cap. On March 13, the generic 10-year yield fell below 0.20%, around a seven-month low. It settled last week a little below 0.30%. The macroeconomic data is pushing in the same direction: there is no urgent need to tighten policy. Domestic demand is weak, and although exports rose on a year-over-year basis in January for the first time in five months, foreign demand may be undependable. Price pressures are moderating, and the sharp fall in the February Tokyo CPI to 3.4% from 4.4% presages a similar decline in the national figures. They will be reported on March 24, shortly before the flash PMI.
Ironically, with pressure on the yield cap and inflation falling, the need for urgent action has lessened; it could be an opportunity to adjust policy. The next BOJ meeting, Ueda's first as governor, is not until the end of April. Note that the Topix bank share index fell nearly 20% from a five-year high on March 9 before stabilizing ahead of the weekend (which seems unlikely to last, given the performance of European and American bank shares before the weekend). As a result, the year's gains were wiped out in full plus more (-3.3% year-to-date).
The dollar fell to one-month lows near JPY131.55 ahead of the weekend as US rates tumbled. Recall that dollar recorded the year's high slightly below JPY138 on March 8. Last week, the dollar often traded below its lower Bollinger Band (now ~JPY132.45) and settled the week below it. The momentum indicators are falling, and the five-day moving average crossed below the 20-day moving average for the first time since early February. The next retracement target is around JPY131.30; below there, the near-term risk extends to JPY129.75-JPY130.00.
Eurozone: After last week's ECB meeting, the eurozone economic calendar in the week ahead is light. Germany's ZEW and the flash PMI reading are the highlights. The adjustment to interest rates has been considerably more dramatic than the economic data. The German two-year note yield fell from nearly 3.35% on March 8 and finished last week below 2.40%, despite the ECB's 50 bp hike. The Stoxx index of eurozone banks fell by about 18.5% from March 7 through the end of last week. It had a strong start to the year, gaining more than 23% through March 3. Like the US yield curve (2-10 yr), if less dramatically, the German curve became less inverted. The German curve went from around -70 bp to a little less than -30 bp. The US curve was inverted by a little more than 105 bp on March 8. It flattened to about -40 and settled finished the week around -52 bp.
The euro's range on March 15 is important. It set a one-month high near $1.0760 and fell to a two-month low around $1.0515. The potential key reversal it posted then did not see follow-through selling, and instead, the euro consolidated with a higher bias to $1.0685 before the weekend. The five-day moving average crossed above the 20-day moving average for the first since early February. However, the momentum indicators are not generating robust signals. The MACD is moving sideways, though off the trough, and the Slow Stochastic is rising but looks tired. That said, the euro has risen in six of the past seven sessions. The US premium over Germany on two-year money fell to 130 bp at the start of last week (near 170 bp at the end of February) and steadied below 160 bp.
China: China has a light economic calendar in the days ahead. The loan prime rates will be set, but a move is improbable with the benchmark medium-term lending facility rate being held steady. The 25 bp cut in required reserves at the large Chinese banks, announced before the weekend, is estimated to free up CNY500 bln (~$72.5 bln). As is well appreciated, the yuan's exchange rate is closely managed. Exactly how they do it is not clear. We have long thought the communication channel (iron fist in a silk glove, to be less charitable) is underestimated by observers focused on prices and quantities. In any event, businesses and investors are more interested in the net effect. The "how" is purposely opaque, but the what seems clearer. The rolling 60-day correlation between the changes in the yuan, euro, and yen are elevated at 5–6-year highs. To answer the question of what the PBOC will let the yuan do, the euro and yen seem to point the way. The euro and yen's strength ahead of the week will likely translate into a stronger yuan at the start of the new week.
Canada: The Bank of Canada's conditional pause in its tightening cycle made it the odd one out, with Federal Reserve and European Central Bank signaling higher for longer. Now it looks prescient. As we have seen, there has been a dramatic change in interest rates and expectations. Canada fully participated in the shift. The two-year yield fell from around 4.35% on March 8 to below 3.50% last week. The swaps market implied yield end policy rate tumbled from almost 4.80% on March 8 to 3.50% in the middle of last week, settling the week near 3.65%. The US two-year premium over Canada collapsed from nearly 80 bp to 40 bp last week. While this should support the Loonie, it seems to have been blunted by broader risk-averse developments. Canada reports February CPI on March 21, and the year-over rate is likely to fall below 5.5% after peaking last June at 8.1%. The underlying core rates may prove stickier but could slip below 5%. January retail sales will be reported on March 24 and look for a recovery from the 0.6% decline posted in December, excluding auto sales.
The Canadian dollar was choppy last week. The greenback found support near CAD1.3650, ahead of the 20-day moving average, which it has not violated for a month. It recovered to briefly trade above CAD1.3800. The momentum indicators favor a weaker US dollar, but the risk-off impulses seem to blunt them. Still, once the tensions ebb, the Canadian dollar looks poised to recover. Still, until then, the risk is for a retest on the CAD1.3860 area seen on March 10.
Australia: The dramatic swing to risk-off sentiment is doing the Australian dollar no favors. However, Australia's two-year yield discount to the US has fallen from around 165 bp in early March to about 95 bp at the end of last week. The Reserve Bank of Australia does not meet until April 8, but the market has completely unwound expectations of a hike. At the beginning of March, the futures market priced in about a 70% chance and, if anything, a modest risk of a cut in Q2. The market now sees the 3.60% cash rate target as the peak. The minutes from the March 6 RBA meeting will be published early on March 21 but may be less helpful given the unfolding financial crisis. The Australian dollar found support a little below $0.6600 last week and set a new high for the week ahead of the weekend (~$0.6725). The momentum indicators are constructive. The nearby hurdle is around $0.6740, and the 200-day moving average (~$0.6765).
Mexico: Shunning risk assets and unwinding positioning has taken a toll on the Mexican peso. The elevated volatility weighs, too, by discouraging establishing carry positions. Three-month implied volatility surged from nearly 10.5% to above 15.2%, the highest in almost two years, before settling near 14% at the end of the week. When there were signs of a respite in the financial drama, the peso would jump, giving a sense of what is likely when the crisis does end. Dollar support may be easier to identify than resistance. The dollar held the MXN18.55 area. On the upside, last month's high near MXN19.29 may be a mile-marker, even if not meaningful resistance. The swaps market does not see a Banxico rate cut in the next six months, suggesting that the carry-attractiveness and the near-shoring, friend-shoring investment theme may continue to underpin the peso. The momentum indicators are stretched but show little sign of turning.