Month-end FX Hedge Rebalancing

March 2023 Preliminary 2023 Estimates

The preliminary estimate of month-end FX hedge rebalancing flows points to moderate USD selling against all major currencies except EUR.

• As of Friday, 24 March the US MSCI equity index was broadly unchanged on the month, out-performing other major markets which showed losses. US fixed income, as measured by the FTSE Government Bond Index, was up +3.4%, its third largest month-to-date performance since 1996.
• Although fixed income performed strongly across the board, Citi bank model suggests that both international equity and fixed income investors will likely be USD sellers this month-end.

The sell-signal in fixed income is influenced by assumptions of lower hedge ratios and higher home bias among US based fixed income investors.

• Japanese investors’ needs to increase hedges on well-performing foreign fixed income strengthen the signal to buy JPY and sell USD. On the other hand, strong performance of European and UK fixed income weakens the signals to buy EUR and GBP.
• Citi Bank real money client flows show some JPY and AUD buying in the most recent week, in line with the signal.

USD: Fears over banks continue to drive FX market

The start of the week has been relatively subdued for major foreign exchange rates.

The dollar index has remained close to the lower end of its year-to-date range, hovering between 102.00 and 106.00.

Despite experiencing some initial losses after the Federal Open Market Committee (FOMC) meeting last week, the index has since recovered. On Friday, the US dollar saw a rebound, which was mainly due to renewed concerns about the health of European banks, particularly Deutsche Bank. The bank's share price dropped significantly by around 15% from Thursday's closing price, and its five-year credit default swaps also increased from below 150 basis points on Wednesday to 200 basis points on Friday, according to Refinitiv's data.

These price movements indicate that the steps taken by policymakers, such as the merger between Credit Suisse and UBS, have not yet been sufficient to restore confidence in the banking system. On Friday, when asked if Deutsche Bank was becoming the "new Credit Suisse," Germany's Chancellor Olaf Scholz responded that the bank had modernized and reorganized its business and was a highly profitable bank, with no reason for concern.

According to an EU official, ECB President Lagarde, who was present at a Euro-zone summit in Brussels, sought to provide assurance that the banking sector was robust and that the ECB was fully equipped to offer liquidity to the Euro area's financial system if necessary. She reiterated that, for the time being, there was no "trade-off" between controlling inflation and fostering financial stability.

In the US, Fed officials are becoming increasingly worried about the negative effects of the loss of confidence in US regional banks on the country's economy. Minneapolis Fed President Neel Kashkari, a member of the FOMC this year, stated in an interview that recent banking strains could bring the US economy closer to recession. He added that the extent to which these banking stresses lead to a widespread credit crunch and slow down the economy was unclear, but closely monitored. Market expectations are that the Fed is close to ending its rate hike cycle and may be required to cut rates later this year if the US economy falls into recession. The US currently curve prices in only about 7 basis points of additional Fed hikes and around 80 basis points of cuts by the end of the year. Although the decline in US yields in recent weeks has weighed on the US dollar, I expect further weakness against a narrower range of currencies if fears over a more significant global slowdown increase. Under current conditions, I continue to favour downside for the US dollar against the yen after USD/JPY briefly broke back below the 130.00-level on Friday.

Commodity FX: Banking disruption heightens risk of hard landing

The high beta G10 commodity currencies, AUD, NZD, and CAD, have been the worst performing currencies over the past week, with declines of 1.0%, 0.7%, and 0.5% respectively against the USD. While the G10 commodity currencies have managed some gains against the USD since global banking fears intensified in recent weeks, their gains have been much more modest compared to the JPY (+5.0%), GBP (+3.3%), and SEK (+3.0%). Despite the dovish repricing of Fed rate hike expectations, the G10 commodity currencies have failed to derive much support. In fact, there has been a significant shift in Fed rate expectations over the past week, with the US rate market now more confident that the Fed has finished hiking rates and has priced in around 100bps of cuts by the end of this year. As US yields move lower, the US yield curve has steepened sharply, with short-term yields adjusting lower by a larger amount than long-term yields. This has added to investor concerns that the US economy is moving closer to falling into recession, as there is a strong historical pattern of the US yield curve steepening sharply just before or at the start of US recessions. The commodity market has also delivered a bearish signal, with Bloomberg's commodity index on track to decline for the fourth consecutive month, extending the sell-off since last year's peak in June to around -26%. Despite investor optimism over the potential for a pick-up in demand for commodities from China as its economy reopens, downside risks from the loss of confidence in the banking sector and tighter credit conditions outweigh that optimism.

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