Markets rebound after yesterday's rout

Just a week after the collapse of Silicon Valley Bank and Signature Bank, concern over the stability of one of Europe’s largest lenders, Credit Suisse, induced a broad-based capital rotation from equities and the euro into bonds and safe-havens like the US dollar and Japanese yen.

The drop in Credit Suisse’s stock came after reports that its largest shareholder – Saudi National Bank – said it would not provide additional capital to the bank. Investors saw this as a continuation of already negative headlines in the past, after Credit Suisse delayed the publication of its annual report last Tuesday and said that it had found material weakness in its financial reporting in prior years. The bank’s stock lost 30% of its value at the peak of the sell-off but is recovering some ground (+22%) in pre-trading after the Swiss National Bank announced that it will provide additional liquidity ($54 billion) if needed.

The rebound of risk sentiment has not helped lift European equities, which fell 2.9% in yesterday’s trading. The German 2-year government bond yield has started the day with an 11-basis point increase, after having recorded the largest daily fall in three decades. The uptick in interest rate swaps and yields has lifted the probability of a 50-basis point hike from the European Central Bank in today’s meeting to around 50%. EUR/USD is recovering from its worst day of the year and is starting the session slightly above $1.06.

Dollar surges despite weak data

The US dollar rebounded sharply against most peers bar the Japanese yen yesterday. Safe haven demand erupted due to fears of contagion in the banking sector. The negative re-pricing of US interest rate expectations and the steepening of the yield curve had weighed on the US currency, but surging bond volatility and heightened risk aversion overshadowed. The dollar is back on the defensive this morning though amidst a rebound in market sentiment.

The volatility in interest rate expectations and bond markets has significantly ramped up lately, reverberating through to currency markets. Two-year US Treasury yields, which move in step with interest rate expectations, slid over 50 basis points back under 4% briefly yesterday, and have endured their biggest 3-day fall since 1987. Markets are now pricing in a 30% chance of no change and a 70% chance of a 25-basis point hike by the US Federal Reserve (Fed) next week, but 100 basis points of rate cuts by year-end are now being priced in. In the shadows of the market turmoil, US retail sales and producer prices fell more than expected, and the New York Fed’s manufacturing index nosedived to -24.6 in March, from -5.8 in February, and well below market forecasts of -8. The latest data points to easing inflationary fears and rising recession risks, further fuelling the Fed pause and pivot narrative.

The repricing of Fed wagers didn’t weaken the US dollar this time though. Flight to safety into the world’s reserve currency dominated instead. The biggest buying activity was seen against the euro (-1.5%), Swiss franc (-1%), and the British pound (-0.8%) but the Japanese yen, a traditional safe haven, was the outperformer on the day and may hold onto most gains amidst ongoing uncertainty.

Banking sector stress eclipses UK Budget

The British pound sunk back towards $1.20 versus the US dollar yesterday and fell over 2% against the Japanese yen, as investors ditched riskier currencies amid ongoing concerns over the banking system. Against a bruised euro though, sterling rose around 1% to its highest level since late December. The UK Budget was largely a non-event for sterling, despite a £22bn a year giveaway.

UK Chancellor, Jeremy Hunt, unveiled more fiscal stimulus than some had expected and stated Britain is no longer forecast to enter a technical recession, though the economy will still contract by 0.2% this year. Mr Hunt also pledged to halve inflation with the Office for Budget Responsibility forecasting UK inflation to fall to 2.9% by the end of 2023. This should be helped by further declines in energy prices and by the government’s decision to freeze the fuel duty for twelve months and to freeze the Energy Price Guarantee until the end of June. We didn’t expect much of a GBP reaction to the Budget, but external events eclipsed anyway, and amidst the reassessment of monetary policy, markets are now pricing a near 50% chance the Bank of England (BoE) will hold pat next week, although a 25-basis point hike is most likely.

Nevertheless, it’s evident the pound has largely failed to benefit from BoE rate increases in the short term. The average performance of GBP/USD from each Wednesday to Friday that has sandwiched a BoE meeting since December 2021 has been nearly -1%.