Banking Crisis and Global Uncertainty Complicates USD Outlook

Last week’s spectacular collapse of Silicon Valley Bank (SVB), closely followed by Signature Bank, has spooked the markets, raised the spectre of a bank run in the US and opened a Pandora’s Box of pressing questions and concerns for policymakers.

Leading financial figures and politicians have all weighed in with their thoughts on the roots of the crises and what the consequences may be, and the subject has even carved out its own space in the ever-present culture wars.

But no one can argue with the direct cause of the collapse: Interest rate rises. SVB had loaded up on supposedly safe long-duration bonds and found itself stuck with a mountain of unrealised losses as the Fed raised interest rates to combat inflation.

Everyone, from the Federal Reserve to investment banks and retail traders, has been watching US inflation figures carefully for months, looking for some hint of a cooling off in the US economy. It has become conventional wisdom among markets and traders that the Federal Reserve will continue to raise interest rates as long as inflationary pressure persists.

Ahead of the FOMC meeting next week, analysts had predicted a rate rise of 25 or 50 basis points. In the days before the SVB’s collapse, Jay Powell himself had intimated that aggressive rate rises for a longer period of time were necessary to stave off inflation in an unexpectedly strong labour market.

Goldman Sachs themselves stated that they were holding to their forecast for a quarter-point hike at the FOMC meeting but that it was a “close-call” between that and a half point.

All that has changed. Economists are split over the level of interest rates the financial system can withstand, and the Fed has a remarkably tough decision to make. Which is a greater threat to stability? Inflation or rapid rises in interest rates?

Late on Sunday, economists at Goldman Sachs switched their expectations from a quarter-point increase to no rate rise at all, noting “considerable uncertainty about the path beyond” that point.

Other analysts still see a quarter-point rise, but there is serious doubt over that. Futures contracts have priced in a 35% chance of a March pause, according to the CME FedWatch tool, while a quarter-point hike has 65% odds.

So where does the USD go with this muddy outlook? The unfortunate answer is that’s impossible to tell. There are too many factors at play, and the situation is too fluid. If you put a gun to my head, I would agree with Ben Winck at Reuters. Inflation is too big a threat for the Fed to hold back, and the systemically important banks are in good shape. I would expect continued rate rises and a further strengthening of the USD as investors baulk at the uncertainty and return to haven assets.

In our podcast two weeks ago, we discussed the medium-term outlook for the USD with Chris Weston, Head of Research at Pepperstone. Chris made the point that, while everyone was focused on interest rate rises, the bigger picture shows a global recession looming. And that when the interest rate merry-go-round stopped, the volatility would kick in.

Today we wake up to the very real possibility of collapse at Credit Suisse, a far larger bank than SVB or Signature, a 200-pip collapse in the EUR/USD and global shares in freefall.

Chris Weston also pointed out that “everyone loves volatility until they have to trade it.”

This is what he meant:

Trade carefully!