Markets Remain Nervous

Yesterday, I described how financial markets seemed to be experiencing a 'nervous calm'. However, this has changed as the focus shifted to Europe, with pressure mounting on Credit Suisse's share price after The Saudi National Bank, one of its top investors, announced that it was not open to a further capital injection into the bank. As a result, European bank stocks have suffered heavy losses, causing increased stress levels in money markets.

Currently, the 3-month USD FRA-OIS spread has widened back out to +57bp (similar to Monday's peak), and the 3m EUR cross-currency basis swap has also widened from 15bp to 38bp since the start of European trading. It's important to remember that the cross-currency swap represents the additional cost that the interbank market is willing to pay to secure USD funding using the EUR swaps market. This was a crucial measure of stress during the 2008 financial crisis and again during the start of the pandemic in March 2020.

FX markets switch mode

In recent quarters, I've observed that FX markets have been influenced by the US inflation/Fed tightening story. However, today, financial stress seems to be the driving force in the market. The EUR/USD pair is selling off as the dollar benefits from the extreme end of its smile curve, which is causing a lot of market dislocation. Additionally, pressure on European banks has led to a repricing of tomorrow's European Central Bank meeting. What was previously expected to be a solid 50bp hike from the ECB has now been reduced to a 35bp hike.

The Japanese yen has emerged as a standout performer in the FX market, with global interest rates converging on those in Japan. The Swiss franc has also seen some appreciation, albeit to a lesser extent. However, USD/CHF is currently higher today as money market stress is leading to broader dollar strength. As we discussed last week, it appears that investors are still unwinding some of their favourite trades in the Mexican peso and the Hungarian forint, both of which are down over 2% today.

Renewed financial stress is certainly not good news for commodity currencies either. The Norwegian krone, which, along with the Swedish krona, trades at the highest volatility in the G10 space, is down by close to 2% against the dollar today. It's clear that the current market conditions are causing significant volatility across the board, with financial stress being the primary factor driving FX markets at the moment.

What next?

From what I can see, it's clear that it will take some time for financial conditions to settle. Although the Fed has announced greater oversight for mid-sized US banks, investors may still want to hear of more support from monetary and regulatory authorities. Additionally, investors will be keeping a close eye on the take-up of the Fed's new liquidity scheme, data on which should be available tomorrow evening.

Given that the US MOVE index for US Treasury volatility has now spiked above March 2020 levels and the VIX (US equity volatility) is heading back to 30%, it's not advisable to look for carry/yield in FX markets right now. Instead, a safety-first approach will dominate until developments in the banking system become clearer. This means that the JPY is likely to continue outperforming on the crosses and may even continue to outperform the dollar.

However, a re-pricing lower of the Fed curve will not necessarily result in a lower dollar until money market conditions smooth out and some confidence is restored to the banking sector. In short, it's best not to be too quick to resell the dollar. Overall, the current market conditions are quite volatile, and investors should exercise caution until more stability is achieved.

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