Banking Crisis Roils Capital Markets, Overshadowing High-Frequency Data

Originally posted on March 25, 2023

The banking crisis is the newest shock to roil the capital markets. Pragmatic action by central banks, governments, and the private sector has thus far been insufficient to allow investors to be confident that the problem is ring-fenced. Credit Suisse (CS) was a pre-existing problem that flared up to the breaking point. The government's offer to take the first CHF9 billion in losses and the controversial triggering of clauses allowing AT1 bondholders to be liquidated before shareholders continue to ripple through banks' shares and derivatives, as other banks have similar covenants as Credit Suisse. The European Central Bank and the Bank of England reassured investors that equity investors would be wiped out before the AT1 bondholders in the eurozone and UK. Invesco's AT1 ETF fell 8.3% last week, its seventh consecutive weekly decline for a cumulative loss of 21%. Meanwhile, the use of Fed's facilities as lender of last resort continued to be elevated. The KBW US bank index (BKX) slipped by about 0.5% last week. It moved lower in six of the past seven weeks, losing around 30% of its value.

In the US, the fear of a systemic crisis prompted the Federal Reserve, Treasury, and FDIC to invoke a clause that allowed making uninsured depositors whole. Over the past decade, there have been more than 560 US bank failures, and uninsured depositors are often made whole after the bank's assets are sold, but not always. Although a group of regional banks sought to extend FDIC coverage for all depositors for a couple of years, federal officials seem reluctant to move in that direction. Just like the BOE and ECB stressed that the Swiss decision on AT1 bonds was no precedent for them, Treasury Secretary Yellen underscored that making uninsured depositors whole at SVB (SIVB) and Signature Bank (SBNY) was not a blanket guarantee. The critical threshold is systemic risk. Therein lies the rub, SVB was judged too small to be subject to the regulator rigor of a systemically important financial institution, yet it was judged to pose systemic risks. Still, there were over 4100 US banks at the end of last year, and only a small fraction found the adverse rate environment overwhelming.

The impact on monetary policy expectations will last longer than the elevated stress itself. The deflationary thrust of the financial stress, including the expected tightening of lending standards, is tantamount to some degree of tightening, even if economists' estimates vary. Consequently, the monetary tightening cycle previously seen extending into Q3 looks set to end sooner, perhaps here in Q1 or Q2. While this may excite inflation expectations, it is not showing up in market metrics. The German 10-year breakeven (difference in yield between the conventional yield and the inflation-linked security) fell from a 10-month high of almost 2.70% on March 6 to about 2.06% at the start of last week. It finished the week slightly above 2.25%. The US 10-year breakeven dropped from near 2.55% on March 3, a four-month high, to below 2.10%. It settled a little above 2.20% ahead of the weekend. The decline in the UK 10-year breakeven fell from almost 3.75% in early March to 3.50% at the end of last week.

United States: The FOMC meeting is out of the way, and will not meet again until May 3. The banking crisis and the consequential tightening of financial conditions is a new deflationary shock. It renders the next data highlight, the February PCE deflator, less relevant. In any event, the March figures will be out before the Fed next meets. That said, a 0.3% monthly increase would translate into a year-over-year rate of 5.1%, matching the slowest pace since September 2021. A 0.4% rise in the core rate could see the year-over-year rate tick up for the second consecutive month (4.8% from 4.7%). In addition, a 0.4% core increase would bring the three-month annualized rate to almost 5.4% (from about 3.6% in Q4 22). Contrary to the clear signal from Fed Chair Powell, the Fed funds futures are pricing in dramatic easing in the coming months. The August Fed funds futures imply a 4.25% 75bp of cuts over the next three meetings. The January contract implies a year-end average effective rate of about 4.0%. This is extremely aggressive and stretches the imagination.

After briefly dipping below 102 on March 23 to reach its lowest level since early February, the Dollar Index bounced before the weekend. It nearly met the (38.2%) retracement of the decline since the four-month high was set in early March found by 103.45. The next (50%) retracement target is in the 103.90-104.00 area, and the 20-day moving average is slightly higher (~104.20). However, the momentum indicators have yet to turn up. Our chief concern is that Fed expectations seem too much, and a modest correction could help the dollar recover. Still, we look for a weaker greenback on a medium- and longer-term view.

Eurozone: The preliminary March CPI is the data highlight as Q1 ends. The issue is the extent to which eurozone inflation is going to fall. Recall that last March, headline CPI jumped 2.4% on the month. Even if prices rose in March the same as in February (0.8%), the year-over-year pace would decline to 6.9-7.0% from 8.5%. In the three months through February, eurozone inflation has risen less than 1% annually. After falling in November-January by a cumulative 0.7%, it rose by 0.8% in February. That said, the core rate may tick up to new cyclical high (median forecast in Bloomberg's survey is 5.7% vs. 5.6%). The swaps market had a quarter-point hike nearly fully discounted for the ECB's next meeting on May 4, but before the weekend, amid more bank anxiety, the odds of a cut were trimmed to about 65%.

Twice last week, the euro was turned back after pushing above $1.09. It eased to around $1.0715 before the weekend, retracing about half of its rally from the March 15 low (~$1.0515). The $1.0825-50 area may cap initial upticks, and corrective action may extend to the $1.0650-75 area.

China: The world's second-largest economy is recovering from the Covid pivot disruption. The question is about the breadth and speed of the recovery. The official March PMI (as opposed to the Caixin version) will be released the first thing on March 31. Somewhat slower activity is expected. Chinese officials continue to allow the yuan to track the euro and yen's movement against the dollar. The rolling 60-day correlation with the yen reached its highest level since early 2017 (~0.57). The correlation with the euro reached a new five-year high (~0.65). The dollar's bounce ahead of the weekend lifted it to around CNY6.8825. It was the second consecutive weekly dollar decline. While China seems immune to the banking stress in the US, Europe, and some Asian centers, many observers highlight the debt problem simmering below the surface.

Japan: February employment, industrial production, housing starts, and retail sales will be reported. However, it will be the March Tokyo CPI that will draw the most attention. Recall that the sharp decline in February CPI from 4.4% to 3.4% reflected the start of the government energy subsidies and was reflected in the national figures as well. Although another decline of a similar magnitude is unlikely, further easing of price pressures is likely. The BOJ's current forecasts (to be updated at next month's meeting) looked for the core CPI to fall to 1.6% this year. It stood at 3.3% in February.

The dollar slipped below JPY130 before the weekend to reach JPY129.65, its lowest level since early February, and slightly through the lower Bollinger Band (~JPY129.90). As US rates stabilized, the dollar returned toward sessions highs around JPY130.95. The momentum indicators are stretched, but there is scope for additional losses. The February low was near JPY128.00. Still, the US rate move seems exaggerated, and recovery in US rates will likely coincide with a stronger dollar.

United Kingdom: The Bank of England delivered a 25 bp rate hike last week to bring the base rate to 4.25%. Although a bit more optimistic about the economic outlook, the BOE seemed somewhat dovish. It revised its outlook for Q2 growth from a 0.4% contraction to a slight rise. However, it seemed to look through the unexpected increase in February core CPI (6.2% vs. 5.8% in January, while the median forecast in Bloomberg's survey was for 5.7%). The BOE reiterated its expectation that inflation will still fall sharply this year. Before the weekend, February retail sales were reported well above expectations (1.2% vs. 0.2%, and the January increase was revised to 0.9% from 0.5%). It also dropped its assessment that the risks to inflation were skewed higher. The BOE recognized that the banking turmoil boosted economic and financial uncertainty. The swaps market leans towards one more hike in the cycle.

Sterling reached a four-month low near $1.18 in early March and almost $1.2345 last week. On March 22-23, sterling met good sellers on the intraday move above $1.2300 and briefly traded below $1.22 ahead of the weekend to retrace almost 50% of its gains since the March 15 low (~$1.20). However, the near-term risk may extend toward $1.2135.

Canada: The dollar bloc currencies underperformed last week, though the Canadian dollar was nearly flat. The lower-than-expected February CPI reinforced the Bank of Canada's conditional pause. It slowed to 5.2% from 5.9%. An even sharper decline is expected when this month's estimate is published when last March's 1.4% increase drops out of the comparison. Over the past three months, Canada's CPI has risen at an annualized rate of around 1.2%. January's monthly GDP is out on March 31. The economy was stagnant in Q4 '22 and the median forecast in Bloomberg's survey sees another stagnant quarter before contracting in Q2. Still, the jump in January retail sales reported before the weekend (1.4% vs. expectations for 0.7%) is consistent with the central bank's assessment that growth at the start of the year is stronger than it expected.

The US hit a two-and-a-half-week low on March 23 (~CAD1.3630) and bounced strongly to poke slightly through CAD1.3800 the following day, ahead of the weekend. It settled in the middle of the session's range (~CAD1.3745). A five-month high was set earlier this month near CAD1.3860, and there is little on the charts to suggest it will not retest it. After pulling back over the last couple of weeks, the momentum indicators appear poised to turn higher. A move back below CAD1.3700 would weaken the near-term technical outlook.

Australia: The recent central bank meeting minutes confirmed the direction in which the market had already moved. The RBA is seen joining Canada with a conditional pause when it meets on April 4. It is not a question of data, as other central banks have framed it. Instead, it will reconsider a pause to allow time to assess the outlook, with the monetary setting already restrictive. The preliminary composite PMI fell back below the 50 boom/bust level to more than reverse the February bounce, and new orders fell to their lowest level since September 2021. February retail sales due March 28 likely slowed sharply, after surging 1.9% month-over-month in January. The developed monthly CPI is expected to show prices continued to moderate after peaking at the end of last year. Australian consumer prices rose 8.4% last year, and in the 12 months through January slowed to 7.4%. That said, policymakers still seem to prefer the quarterly estimate because not all items in the basket are updated monthly.

The Australian dollar approached its 200-day moving average (~$0.6760) last Wednesday and Thursday, and settled well off its highs on both days. It was sold to $0.6625 ahead of the weekend, a six-day low. The next area of support is near $0.6600, and then the low from March 10 around $0.6565. A break of $0.6550 would weaken the medium-term technical outlook.

Mexico: Inflation moderated in the first half of March slightly, and given the Fed's quarter-point rate hike, Mexico's central bank will likely deliver a 25 bp hike as well, which the swaps market says will probably be the last. The banking crisis spurred risk-off position adjustments, which weighed disproportionately on the fact that the peso had been the strongest currency this year, and surveys showed that fixed-income managers were mostly overweight. We remain concerned about the political developments in Mexico and tensions with the US but suspect that the attractive interest rates and the near-shoring/friend-shoring meme will see new buying of the peso. The dollar spike to a three-day high of almost MXN18.80 before the weekend and reversed to settle below the previous session's low, posting a bearish outside down day. Last's week's low was close to MXN18.38, and below there, support MXN18.20. Mexico's three-month cetes (T-bills) yield 11.6%. The US three-month bill yields about 4.55%. A one-month hedge (forward points as a percentage of spot) costs around 0.60-0.65%.

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.