Is the Fed’s tightening cycle over?

The dollar erases 2023 gains as yields plunge, while the pound is buoyant amid SVB turmoil.

George Vessey, UK FX & Macro Strategist

The collapse of Silicon Valley Bank (SVB) has reverberated across global markets. Investors have ripped up their forecasts for further rises in interest rates, scooping up government bonds and sending the yield on the two-year US Treasury note plunging the most in decades. Consequently, the US dollar has nearly completely erased its 2023 gains, with GBP/USD and EUR/USD rising to 3-week highs.

The probability of a 50-basis point rate hike by the US Federal Reserve (Fed) was above 50% last week after Chair Jerome Powell addressed lawmakers. Now, markets are pricing a 53% chance the Fed won’t hike at all next week, with a 47% probability of a 25-basis point hike. Is the Fed’s tightening cycle over? The repricing shows how swiftly monetary policy expectations can be upended as signs of systemic risks emerge. Some forecasters, such as Nomura, are even predicting the Fed to cut rates at their next meeting. Amidst the tremors in the banking system and elevated recession fears, the Cboe volatility index – Wall Street’s so-called “fear gauge” – spiked above 30 for the first time since October and global equity indices are sliding despite rising speculation of interest rate cuts. Focus turns to today’s US consumer price index (CPI) report which will be important for market participants and policymakers as stubborn inflationary pressures might send rate expectations and yields higher once again. The annual inflation rate is seen easing to 6%, while the monthly rate is forecast at 0.4%. Also, core consumer prices are forecast to have risen 0.4% over the previous month, resulting in the annual rate easing to 5.5% from 5.6%. Falling delivery times and SME pricing plans point to an easing of inflation over the coming months, but short-term pressures may persist.

Consequently, opposing forces are at play once again – markets are speculating on a Fed U-turn in light of recent stress, but if inflation comes in hotter-than-expected today, the Fed may push back against this aggressive shift in sentiment. This may lead to a reversal of GBP/USD as the pair’s upward momentum appears to have stalled just shy of the $1.22 mark. However, the balance of risks appear tilted to the downside for the dollar as the CPI report could be overshadowed by the ongoing turbulence in the banking sector.

Pound buoyant amid SVB turmoil

The British pound is benefiting from the biggest bank collapse since the 2008 financial crisis as it has forced investors to rethink the Fed’s aggressive rate-hike trajectory. GBP/USD jumped over 1% yesterday, marking at 3.3% recovery from 4-month lows last week. Meanwhile, the UK labour market report this morning has been largely overlooked, whilst markets price a 50% chance the Bank of England (BoE) will stand pat with rate rises this month.

The BoE stated yesterday that Britain’s banking system was sound after the central bank helped to find a buyer for the British arm of SVB. Ahead of his Budget announcement tomorrow, UK Chancellor Jeremy Hunt said the rescue was necessary to help protect some of Britain’s most important technology companies. Sterling’s recent recovery has lost some traction after today’s UK jobs report showed sign that tightness in the labour market may be easing. The unemployment rate remained unchanged, leaving 1.25 million people out of work and looking for a job, but wage growth slowed for the first time in more than a year. Total pay growth eased to 5.7% y/y in the three months to January, while in real terms, wages dropped by 3.2%, the largest decline since the February to April 2009 period. Signs of labour market cooling may encourage speculation that official UK borrowing costs are close to peaking.

Attention remains on the banking sector though and the implications for financial markets. As a pro-cyclical currency, sterling has proved resilient in the immediate wake of the turmoil. Against the euro, the pound has risen over 1.5% from last week’s low but remains confined to a narrow trading range between €1.11 and €1.14.

ECB: Losing credibility or retaining flexibility?

While the European Central Bank (ECB) is expected to continue its tightening cycle on Thursday, doubts about the pre-committed 50-basis point rate increase have crept into market pricing. The probability of such a move has fallen below 50%, in line with the re-pricing of the expected terminal rate from 4.10% to 3.40%.

The ECB seems stuck between responding to a global risk event with a flexible approach and going ahead with the already flagged half-point increase. Policy makers might worry about losing credibility and could strike a balance between the hawks and doves within the Governing Council. A 50-basis point hike could be followed by a signal that a downshift in the pace of further rate increases might be warranted. Communicating the reaction function of the central bank to the potential fallout from the US banking system and incoming data will be key, as disagreements between the ECB’s policymakers have gained traction in recent weeks.

The sudden spike in the two-year swap differential between the Eurozone and US to above -100 basis points for the first time since October has lifted EUR/USD to around $1.0750. However, the euro has had a hard time holding on to yesterday’s gains in today’s early trading session. It seems that the negative global risk sentiment and uncertainty regarding the contagion risk to the broader banking system have kept the euro from advancing further.

USD falls by over 1% versus JPY

Table: 7-day currency trends and trading ranges

Key global risk events

Calendar: Mar 13 -Mar 17

Have a question? [email protected]