FX Daily: Risk Re-assessment?

Jitters in European banks on Friday fuelled a recovery in the dollar against pro-cyclical European FX. Markets are once again forced to re-assess the risks in the two epicentres of the banking crisis (US and Europe), and that will drive much of the G10 FX swings this week. Still, monetary policy differentials seem to point more clearly to a higher EUR/USD.

USD: Dollar support comes from Europe

In the past two trading sessions, I noticed that the dollar has regained some ground, but this is largely due to developments overseas (in Europe) rather than any significant improvement in US-related drivers. I observed that the demand for the dollar as a haven is mostly related to banking stress on the other side of the Atlantic. The Federal Reserve's lack of clear communication has left rate expectations, and by extension, the dollar, strictly tied to US financial stress.

I observed that the markets are becoming increasingly doubtful that the Fed will be able to tighten its policy any further, and some are even speculating on an early start to the easing cycle. Currently, Fed funds futures only price in a 30% chance of a rate hike in May. The variables that currently drive pricing for Fed hikes/cuts are developments with US regional banks, the stance of the US Treasury on extending deposit insurance, and Fed speak. I think the news flow on the first two points may still be rather volatile as the US regional banking crisis has not gone away, with deposits either leaving the banking system altogether or being moved to larger institutions, and there are still multiple banks being highly scrutinised.

Regarding Fed speak, I heard from Neel Kashkari over the weekend. While he is normally one of the most hawkish voices in the FOMC, he sounded quite alarmed about the risks of a credit crunch hitting the economy and generating a deeper economic slump. In a week without much exciting data in the US, such as consumer confidence and PCE, Fed speakers will be in focus.

From an FX perspective, I noticed that the resurgence in banking stress in Europe forces me to soften my bearish dollar view for the moment, at least until I can get more clarity on the stability of the EU banking sector. Still, I continue to see the Fed as mostly carrying downside risks for the greenback, as the lack of clear communication leaves the door open for dovish speculation. The US regional crisis remains unresolved, and it is keeping the monetary policy outlook in the US in stark contrast (for now) to that of most European central banks. On balance, I see more balanced risks for DXY this week, but volatility may remain elevated, and if anything, my preference remains for a higher EUR/USD.

EUR: Reassessing risk?

I perceive that markets' risk perception on Deutsche Bank and other European lenders jumped last Friday, causing financial stress to return to Europe after a long period of tentative calm as markets digested the fallout from the Credit Suisse takeover. Today, futures indicate a rebound in European equities, possibly suggesting last week's concerns may have been overdone. However, recent events have taught us that market conditions can change extremely rapidly in the current environment, and Friday’s turmoil suggests that confidence among European bank bondholders is far from fully restored after the Credit Suisse saga.

Although I generally favour a higher EUR/USD due to monetary policy divergence, last Friday's events cautioned me not to assume that this banking turmoil is solely a US issue, and therefore, a straight-line bullish EUR/USD. Still, I believe that a move to 1.10 in the coming weeks remains a very real possibility. For this week, I will welcome a sign of the EUR/USD bulls if it re-tests 1.0900.

GBP: All eyes on Bailey

Domestic drivers for the pound are concentrated at the front this week. Today, we’ll hear from Bank of England Governor Andrew Bailey, and his words will be weighed very carefully by markets given that the March BoE meeting did not include a press conference. Markets are already pricing in another hike by the summer, so the bar for a hawkish surprise to lift GBP does seem relatively high. A few of my friends that are economists do not expect any more hikes.

With virtually nothing to highlight on the data side, GBP may be moved by Bailey’s words but should rapidly default to being driven by external factors. Essentially, GBP/USD is a USD story and EUR/GBP is a EUR story. I still think cable can reach 1.2500 this quarter, and that the EUR looks marginally more attractive than GBP, and EUR/GBP should move back to 0.8900.

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