G10 FX Weekly: Trading USD Amid the SVB Chaos and Fed Repricing

Summary

• The collapse of Silicon Valley Bank (SVB) has rocked rates markets globally, with extreme pressure on Credit Suisse (CS) weighing on bank stocks in Europe.
• The FX market has also reacted forcefully, albeit less so than other asset classes.
• The US dollar has traded choppily but within established ranges. We expect year-to-date (YTD) 2023 ranges to hold in the coming weeks.

Market Implications

• In EUR/USD, the downside (~1.05) of the recent range has been tested and held, bouncing back near the middle of the 2023 price corridor. In the medium to long term, expect upside in the pair.
• In USD/JPY, the ~127-137 range has contained the pair in 2023 – it will keep doing so in coming months.
• In GBP/USD, the pound briefly fell below the earlier 1.19-1.25 range before bouncing back above the support. We remain bearish sterling long term, preferring to fade GBP strength.

Introduction

Rates markets have reacted violently to the Silicon Valley Bank (SVB) collapse last Friday and the run on European bank stocks catalysed by the sharp selloff in Credit Suisse (CS). There was a sharp retracement higher in yields on Tuesday, followed by a sharp fall yesterday.

In the US, the two-year yield now sits below 4%, after printing a new YTD low this week. On Monday, the yield fell ~61bp, the biggest one-day move since Paul Volcker chaired the Fed, trading below 4%.

That same day, the German two-year now sits just above 2.5%, off over 80bps from the peak yield near 3.4%. It now lingers near that yield trough ahead of the ECB policy announcement today.

By contrast, although not immune to the volatility seen in the rates markets, FX markets have reacted more sanguinely. True, trade has been choppy and volatile, but it has been much more contained than in the rates space.

Most major G10 FX pairs have traded within the established (pre-SVB) YTD ranges. The initial knee-jerk reaction was for USD to weaken against many of its G10 counterparts, and in most cases that initial price action has held despite some notable corrections.

In the near term, we expect few of the major USD pairs to break out of the 2023 ranges. Further ahead, we expect divergences. In this piece, we examine EUR/USD, USD/JPY and GBP/USD.

The Rates Markets, the SVB Collapse, and CS Slide

We first consider how the rates markets reacted to the failure of SVB last week and how the failure has impacted (and may influence) central banks going forward.

The US Rates Market Reaction and the Fed

Only last week Fed Chair Jerome Powell testified to Congress with a decidedly hawkish take on the US economy.

As my Macro Hive colleague Dominique Dwor-Frecaut recently wrote, Powell’s messaging put a 50bp hike for this month’s FOMC meeting firmly back on the table.

And, in the immediate aftermath of Powell’s comments, short-end traders largely bought into this narrative, with market pricing leaning towards a 50bp Fed hike on 22 March.

Then, of course, the SVB news hit, and the US rates market went haywire. The bond market rally was eye-watering, with current pricing torn between the Fed remaining on hold or tightening by 25bp. Farther out on the curve, there is now substantial easing priced before year-end.

As an aside, part of the reason the drop in short-end US yields was so explosive was due to crowded short positioning. While elevated short-end yields, the highest in over a decade, would also be enticing and start to attract buyers, by-and-large the market was still overwhelmingly biased short.

Using CFTC data dating back to the 1990s, shorts from speculators in the 2-year UST note futures were at record levels.

Currently, the two-year US yield is just under 4%, having been above 5% last week. Expect volatile price action to continue into the Fed rate announcement next week.

The Euro-Area Rates Market and the ECB

The reaction to SBV from European bond markets was equally as pronounced as in the US market, and traders are eagerly awaiting the ECB rate announcement today.

The slide in CS shares, together with the sharp fall in the broader European banking index, added a further local input into nervous markets.

The volatility in the two-year German yield is also evidence of the turbulence in US markets.

With the dust settling somewhat, the market is preparing for another ECB rate hike today. The question is, will it be 25bp or 50bp? Before CS shares started to slide, the market was pricing over a 90% probability of a 50bp hike. The market is now pricing a 25bp rate rise.

Conveniently, an ECB source told Reuters yesterday that the Governing Council is leaning towards a 50bp hike today, despite banking sector turmoil. The main reason for this hawkish bent is that the central bank expects inflation will remain too high in the coming years.

My Macro Hive colleague Henry Occleston also says the ECB will hike by 50bp. Moreover, Henry thinks the ECB policy rate will peak over 4%.

The Japanese Rates Market and the BoJ

The Japanese Government Bond (JGB) market is much less volatile and less frequently traded than other developed bond markets. This is due to the Bank of Japan’s policy of Yield Curve Control (YCC).

And yet, in recent days, JGB yields have not been immune to the tumult in other G10 bond markets. This week saw the 10-year JGB yield fall below 0.25%, which was previously the BOJ’s YCC ceiling.

Moreover, the global rates market turmoil saw most of the expected changes to the YCC policy priced out earlier this week.

The BOJ’s Haruhiko Kuroda has overseen his final meeting as BOJ governor, to be replaced at the head of the central bank by Kazuo Ueda. This change in leadership, together with the recent volatility in the bond markets, suggests uncertainty with BOJ policy.

In a recent conversation with Bilal Hafeez, Mikihiro Matsuoka of SBI Securities characterised Ueda as dovish, but also cautious and likely to engage in incremental monetary policy moves rather than abrupt ones (listen to the podcast here).

The UK Rates Market and the BoE

UK gilt yields have also whipped around as in other developed markets, and key event risk comes next week when the BoE announces its next rate decision.

Markets are pricing slightly over a two-thirds probability of a 25bp hike.

Henry has been dovish the BoE for some time and expects it to pause hikes soon. Pressure on the UK consumer is one of the main reasons for his dour outlook on the UK.

Henry argues that UK consumers are less supported by fiscal policy than in the US and the euro area, have been less insulated from energy prices, and will be affected by higher rates sooner.

UK household savings will face increasing pressure into 2023. This should provide the BoE more room for dovishness.

A Look at Three USD Pairs

Despite the outsized volatility in developed rates markets, the USD has taken the SVB news broadly in stride. We consider EUR/USD, USD/JPY and GBP/USD below.

EUR/USD

In the initial reaction to the SVB news, EUR/USD traded to ~1.0750, back near the middle of the 1.05-1.10 range we highlighted in this piece. After the CS news broke, the pair slumped below 1.06. It now hovers above 1.06.

In the near term, it all comes down to the ECB. Should the central bank raise rates by 50bp, as we expect, EUR/USD should initially trade back to 1.0750.

And, if Christine Lagarde and her colleagues raise rates by 50bp, expect them also to address concerns about the banking sector by highlighting other tools that can be deployed.

Longer term, we remain constructive on the pair for reasons outlined here and see it trading above 1.10 this year.

USD/JPY

USD/JPY is trading very near the middle of the ~127-137 range seen YTD, having fallen five big figures since the SVB/CS news hit the wires.

Depending on the news flow between now and next week’s Fed meeting, expect the pair to chop around near this midpoint. The Fed’s decision next week will be the decisive driver of near-term price action.

Longer term is less clear. For the foreseeable future, we expect the 2023 range to hold and favour fading the extremes.

GBP/USD

After briefly breaking below the ~1.19 support last week, GBP/USD is now back above the support on broader USD selling.

While this first move below 1.19 has proven to be a false break, we think it is a sign of the weak side of the market.

As we said in this piece, we remain bearish on the pound over the medium term and still favour fading any sterling strength going forward.

With both the Fed and BoE meetings next week, expect the pair to tread water until then. However, once the rate decisions are announced, GBP/USD could fall back below 1.19.

Conclusion

Volatility has rippled across all asset classes after the failure of SVB and the pressure on CS and other European banks.

While G10 rates markets have seen some of the wildest moves in decades, reactions in the FX markets have been much more circumspect. Broad YTD ranges in most of the major currency pairs have held.

The direction of the US dollar will not be uniform across all USD pairs. Heading into a week of major event risk in the form of central bank rate decisions, expect more volatility and wild price swings.

Richard Jones is a Macro Strategist for VDK Capital, a London-based venture capital firm. He has traded and invested in interest rate and FX market portfolios spanning three decades, both on the buy-side and sell-side. 

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)