FX Update: JPY outpacing USD as financial conditions lurch into crisis mode.

Today's Saxo Market Call podcast
Today's Global Market Quick Take: Europe from the Saxo Strategy Team

FX Trading focus: With the contagion from US banks into global banks, the Euro weakens the most due to its former darling status. The JPY soaring even beyond the strong USD as yields pummeled.

Just a quick update to yesterday’s piece as conditions have worsened badly after markets took a valiant stab at stabilizing the situation yesterday. The key development is that the contagion from US banks has widened badly into European banks and especially into the troubled Swiss bank Credit Suisse in the spotlight today. The mark-down in European banks is doubly damaging for the euro due to the rapidity with which ECB hike intentions are being marked down (now tomorrow’s ECB is marked at +35 basis points, with only 40 more basis points priced beyond tomorrow – so a total drop in expectations of -80 bps of tightening, but also as global investors cut exposures to European banks, which have tumbled since last Thursday’s Silicon Valley Bank debacle: the Euro Stoxx Banks Index has dropped some 16%, wiping out the majority of gains for the entire year in what was a strong consensus trade before the latest disruption.

The overlying risk here is in part the entire principle of the role of banks once the US government effectively moved to insure all US deposits in the wake of the Silicon Valley Bank collapse:  why should a traditional bank be allowed to even operate and take risks if all of its deposits (its risk base) are publicly insured? As well, there is a general concern that investors worldwide may shift the location of deposits to perceived safer harbors and demand higher yields on their deposits by moving funds into money markets or shorter maturity government debt, drying up funding for banks that then translates into a credit crunch. There is also a general concern about the murkier portions of the shadow-banking sector, like in private equity, etc., which my be sitting on large portfolio losses if their illiquid assets were forced into liquidation, a situation that isn’t marking current asset values to market (the held-to-maturity accounting principle, for example, allowed SVB to avoid marking its longer duration portfolio bond portfolio to market until it suddenly ran dry of liquidity).

As long as the contagion rages, the USD and especially JPY will continue to swing like twin wrecking balls, with the USD having a bit of a hard time getting more broad traction as USDJPY is the favoured initial move when the JPY gets going – but other JPY crosses should prove more volatile. If the volatility accelerates badly enough, of course, the inevitable intervention will arrive, but the bar is high, given the difficulty of moving too aggressively when inflation levels are still so high. Note Sweden reporting +12.0% CPI YoY in February and 9.3% at the core!

Chart: EURJPY
The situation is unfolding so quickly that I am no longer willing to even forecast what the ECB might do tomorrow, something I thought I could do as recently as this morning. If fear levels deepen further from here, central banks will inevitably move into support, but it is a dance that is far more fraught with danger than the straightforward stave-off-collapse-at-all-costs efforts during the pandemic. The moral hazard risks are even greater and the embarrassment that the current inflation was due to over-spiking the stimulus and zero- & negative rates policy punch bowl the last time around, followed by a vicious tightening that is the direct cause of this mess. In the meantime, the massive marking down of ECB rate expectations and the shift in flows away from the former consensus long-European-banks trade has the euro under enormous pressure, while all of the formerly negative pressure on the JPY as the Bank of Japan refused to play ball with the global policy tightening regime has entirely lifted (as yield spreads to Japanese yields compress). EURJPY could trade back to 130 – or lower and in a hurry if we are headed toward a disorderly market event here.