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FX Update: USD path now depends more on financial conditions than Fed. FX Update: USD path now depends more on financial conditions than Fed. FX Update: USD path now depends more on financial conditions than Fed.

FX Update: USD path now depends more on financial conditions than Fed.

John Hardy

Head of FX Strategy

Summary:  With the sudden onset of a bank crisis in the US and this weekend’s bailout of all depositors, the market now expects the Fed to be in full easing mode within six months. The short end of the US yield curve has suffered a mark-down of historic proportions, but action in the US dollar is relatively muted, likely as nervous financial conditions help the greenback retain some safe haven appeal. Elsewhere, the shocking drop in yields has benefitted the Swiss franc the most among G10 currencies.

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FX Trading focus: The USD, and the Fed for that matter, will likely track financial conditions from here more than incoming data. ECB to hike 50 but downshift guidance?

The sudden onset of a bank crisis in the US last Thursday rippled so rapidly through the system that the Fed and regulators conjured up a bailout of all US depositors of any size at the weekend to avert the risk of a series of bank runs across the country. The Fed created the unfortunately named BTFP – the Bank Term Funding Program – (consult FinTwit for humorous alternative takes on what the letters stand for.) to essentially ensure that banks won’t have to mark their US treasury holdings and other qualifying collateral to market, but essentially can mark it to par. There are reports that Had the Fed and US regulators not moved so quickly, we almost surely be in the midst of a systemic crisis with contagion into nearly all except for the largest banks suffering deposit flight and a horrific spike in funding costs. So in the first instance, the move was likely entirely necessary, but the move brings into question over the longer run what a US bank is even meant to be or why it should be allowed to exist. After all, why should banks be allowed to take significant risks for bond-holders and shareholders when the source of their funding is deposits that are fully insured up to infinity by the government?

As well, if this blow-up serves as a general wake-up call for depositors to park their money in higher yielding money market funds rather than in savings and checking accounts that still often yield almost nothing, banks will struggle with the price of funding and a creeping credit crunch could now be on the way in the months ahead. This has us suddenly watching signs of funding stress and credit spreads far more than incoming data, which will likely now take a back seat. (By the way, US Feb. CPI out in-line with expectations, save for a slightly firmer +0.5% MoM core number). Financial conditions will be more important for the greenback from here than Fed expectations (also likely a derivative of financial conditions as long as these are worsening).

The sudden revelation of how fragilized the US banking sector has become in the wake of the Fed’s  vicious tightening regime saw the market erasing most of the anticipated further Fed policy tightening for the cycle and sharply bringing forward the anticipated timing of an ensuing easing cycle. Since last Wednesday, we’ve gone from pricing in more than 100 basis points of further tightening through the July FOMC meeting and a 5% two-year US treasury yield to pricing in odds of 50 basis points of cuts by the July FOMC meeting at yesterday’s market nadir (now a mere -10 basis points as of this writing), with the 2-year yield trading south of 4% overnight and this morning (now backed up close to 4.25%). Some are already clamoring for the Fed to cut rates while others see a pause or even for at least another 25 basis points of tightening to any sense of panic.

The ECB is in an awkward place with its meeting on Thursday and if conditions remain nervously stable, could go ahead and hike 50 basis points but loosen its commitment to further tightening as it ponders the risk of contagion from the resetting of financial conditions lower after the US bank crisis emerged so suddenly out of the blue. The yield-spread has tightening in favour of the euro since last Thursday with a more aggressive expectation of the Fed to be in cutting mode sometime in Q3, while ECB expectations have merely receive a haircut, and still are looking for Lagarde and company to hike another 100 bps total through the October meeting (with about +40 bps price for this Thursday, i.e., a significant minority looking for a smaller rate hike.) The meeting may not serve as much of a catalyst if financial conditions are deteriorating again over the decision. Technically, watching the 61.8% Fibo retracement at 1.0842 if this psychological 1.0750 area falls.

Source: Saxo Group

The first rule of shock developments across markets is that traders will move first to simply deleverage existing positions to shed risk. That is the most likely proximate driver of an extreme move like the shockingly steep rally in USDMXN since last Thursday. MXN had become a relative star performer starting last year with the notable strength even against a strong US dollar as an EM currency that was in the vanguard of responsibly taking its policy rates to credibly close to or even beyond inflation levels. Further strength has been found on the deglobalization theme as Mexico is seen as a long-term winner in the US friend-shoring and reshoring of manufacturing away from China. A report on February 28 that Tesla would build a gigafactory in Mexico touched off the last leg of USDMXN downside to below 18.00 at times. This sharp backup is a wakeup call for those enjoying the MXN carry trade over the last many months. I have a hard time seeing new lows emerging any time in the near future, given the scale of the back-up here.

Table: FX Board of G10 and CNH trend evolution and strength.
The Swiss franc and gold are getting the most out of the current situation, with the USD so far merely deflating sharply after its recent rally and not yet in a downtrend. Note the relative weakness across most of the G-10 smalls, though note EURSEK comments below.

Source: Bloomberg and Saxo Group

Table: FX Board Trend Scoreboard for individual pairs.
The USD is rolling over into a downtrend in places – note USDCHF and UDSJPY as the most prominent an well developed examples, but the move will need to stick through another couple of days of action. EURSEK posted a smart bearish reversal on a test above the prior 11.44 high.

Source: Bloomberg and Saxo Group

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