US Dollar Bounces, US Rates Fall as Banking Worries Build Ahead of ECB

US Dollar Talking Points:

• Risk aversion flows are showing with USD strength even despite falling US rates, driven by continued worries around global banks. But this time the anxiety is emanating from Europe.
• Fawad Razaqzada and Fiona Cincotta addressed this earlier today, highlighting banking worries in Europe ahead of tomorrow’s ECB rate decision and how that’s impacting US equities.
• I discussed these themes in-depth in yesterday’s webinar and will address them again in the next. Click here to register.

The world was jolted last Thursday as news of trouble at Silicon Valley Bank started to make its way through markets. While a major US bank coming under pressure is notable on its own, it was the potential repercussions that really started to drive the anxiety as the problems that plagued SVB could, logically, be extrapolated to other regional banks. And markets aren’t often willing to wait around as the slightest signs of trouble can lead to more changes in investor and depositor behavior, which can then put the bank under even more pressure.

The weekend announcement of backstopping deposits as SVB and Signature bank were designed to provide calm, as was the Presidential address on Monday. And for a short while, this worked, but the same extrapolation that led to bank stocks getting punished last Thursday still lurks on the margins, and this morning it’s started to show in Europe as Credit Suisse has come under renewed pressure following comments from one of the bank’s largest investors.

Years of low and negative rates have created vulnerability in banks’ investment portfolios as higher rates have taken the world by storm. And tomorrow brings an ECB rate decision where rates are expected to be boosted again, and with inflation at 8.6% last month and 8.5% for this month’s preliminary read, it doesn’t seem as though the European Central Bank is near a point where they can pivot away from rae hikes without risking even higher evels of inflation (and larger problems down the road).

Flight to Quality in the USD

The US Dollar is putting in a bounce and the daily chart is currently showing a non-completed morning star formation, which are often followed with aim of bullish reversals. The point of support that held the lows yesterday, helping to build the doji, was at a familiar level of 103.45, and next resistance shows around the 105.00 handle.

US Dollar - DXY Daily Price Chart (indicative only, not available on Forex.com platforms)

US Rates Falling on Risk Aversion Concerns

When worries mount, investors can eschew return on capital in favor of return OF capital, which can mean abandoning higher-yielding investments for those with greater levels of perceived safety. This usually points to flows into US Treasuries and this morning has seen a stark run of strength in US Treasury prices with yields falling after yesterday’s bounce.

The two-year treasury has seen its yield fall to another fresh six-month-low this morning, completely erasing the bounce from yesterday that had built as hope started to percolate that the banking saga may have been adequately addressed.

US Two Year Treasury Yield

EUR/USD In the Spotlight Ahead of ECB Tomorrow

Inflation remains problematic in Europe as last month’s read came in at 8.6% and this month’s preliminary read tracked closely, coming in at 8.5%. We’ll get the final read of that data point on Friday; but before we get to that we have a European Central Bank rate decision on the economic calendar for tomorrow.

The ECB has been widely expected to hike rates by 50 basis points at this meeting to address that inflation. But, now that there’s problems showing in European banks, there’s a question mark as to whether they’ll deliver that and – if they do – there’s worry about what might happen next.

Higher rates sink the value of bond and fixed income portfolios, and this can create capitalization concerns at those banks as they’re sitting on unrealized floating losses from the fast move of higher rates after years of low and negative rates. Add in a bank run with depositors removing their capital (which removes more collateral from those portfolios), there’s a recipe for disaster.

How might the ECB handle this scenario? We’ll have to wait to find out, but in response the Euro has put in a large move lower ahead of that rate meeting and price currently sits above a key support zone around the 1.0500 handle. This was the same zone that came into play in the first week of the New Year to help hold the lows, leading to an extension of the bullish move up to 1.1033.

If sellers can break price below that support zone, there’s another area with some longer-term interest around the 1.0350 level.

EUR/USD Daily Price Chart

Yen-Strength

I had talked about this on Monday and again in yesterday’s webinar, highlighting the potential for Yen-strength in lower-rate scenarios.

As USD/JPY launched higher for much of 2021 and the first nine months of 2022, the carry trade was driving as higher US rates and low Japanese rates kept the long side of the pair bristling. But, as soon as the rates picture began to turn, so did the USD/JPY pair in mid-October of last year, leading to a 50% retracement in about three months of the trend that took 21 months to build.

The pair caught a bounce from the 50% marker of that move in mid-January, which extended last month as the BoJ began to transition to new leadership to a new Governor thought to be supportive of the bank’s yield curve control policy.

But as rates have started to shift-lower in the US, so has the attractiveness of the carry trade and that’s led to unwind, which highlights USD/JPY as one of the few major currency pairs reflecting USD-weakness on the day. Price is testing below the 38.2% retracement of the same Fibonacci retracement that helped to carve the low in January, and a close below that level highlights 131.58 and 130.40 as next spots of support on the USD/JPY chart.

USD/JPY Weekly Price Chart

Chart prepared by James Stanley, USD/JPY on Tradingview

--- written by James Stanley, Senior Strategist

Follow James on Twitter @JStanleyFX