There were three ways the monetary cycle was going to turn. First, unemployment could have reached unacceptable levels. This did not happen. Labor markets have proven thus far to be resilient among most G10 countries.

Second, a significant and sustained drop in price pressures could end the tightening cycle. This has yet to materialize in a meaningful way. In some countries, governments have energy subsidies, and these measures only offer temporary relief.

Instead of macroeconomic developments turning the cycle, it is the perceived threat to financial stability. Repricing assets to a higher interest rate environment would be disruptive no matter how it was achieved. At the end of 2020, there were $17.76 trillion of negative-yielding bonds in the world. It fell to about $24.5 billion by the end of last year.

This time, the weak link arose from small and medium-sized US regional banks, where deposits were less sticky than anticipated, partly due to higher returns available in money markets and the US bill market and risk management decisions. There are over 4100 US banks, and less than 5% are the focus.

The financial stress was a challenge to investors, and the policy response added to the dislocation. The US decision that banks too small to be regulated posed systemic risk requiring all depositors to be made whole added another level of confusion.

A few hours before Fed Chair Powell said that all depositors were safe at the press conference that followed the conclusion of the FOMC meeting on March 22, Treasury Secretary Yellen told a congressional hearing that the government was not considering insuring all depositors, and the key was systemic risk. This did not prove helpful in staunching the deposit flight from the small and regional banks.

The difficulties of Credit Suisse have been widely known for some time. It was not so much about coping with a higher interest rate environment. The stress on US banks had ripple effects, which seemed to be the proverbial last drop of tea that overflows the cup.

In the forced merger between UBS and Credit Suisse, officials wiped out the AT1 bonds ahead of shareholders. AT1 bonds typically offer a high yield and are sold by banks to raise capital. They are intended to provide a capital cushion that can help avoid using public funds. 

As US officials cited "systemic risks" for choosing to make whole uninsured depositors the Silicon Valley Bank and Signature Bank, Swiss officials declared the pressure on Credit Suisse a "viability event." Given that government support was drawn upon, the Swiss regulator argued that the contractual conditions of completely writing down the AT1 bonds were necessary.

Officials in the UK and EU were quick to say the AT1 bonds in their jurisdictions were senior to equity holders. However, AT1 bonds were marked lower, and the new issuance market was frozen. The exchange-trade-fund of AT1 bonds enjoyed a four-month rally through January (15%) despite it being widely understood that rising interest rates would be challenging for financial institutions.

It slipped by a little less than 2% in February before tumbling more than a quarter at its worst in March (settling down 15%).

With scars from the 2008-2010 Great Financial Crisis and the European sovereign debt crisis still fresh for many investors, there was no waiting "for the other shoe to drop." Bank shares came under pressure, challenging official efforts and assurances that banking systems were robust.

One of the consequences of the US strain will likely be greater regulatory framework for medium-sized banks. There is a risk of greater deposit concentration, which may also help spur further consolidation in the US banking sector. Going forward, official stress tests will likely include a dramatic change in interest rates. AT1 bonds as an asset class may be questioned.

Financial stress is understood to be deflationary because banks will likely tighten lending standards. This was already beginning, according to the Federal Reserve's survey of senior loan officers. The new restrictions on lending are seen as doing some of the heavy lifting for central banks still combating elevated prices.

In early March, the swaps market was discounting almost 5.75% peak Fed funds rate and a 4% Eurozone deposit rate. By the end of March, the market thought the terminal rate in the US was at hand (5.0%).

After the March hike, and despite Fed Chair Powell's claim to the contrary, the market is pricing in at least 50 bp in cuts this year. The ECB's deposit rate sits at 3% after last month's 50 bp hike. The market now sees a peak near 3.50%, down from 4.0% before the banking stress. At the start of March, the swaps market saw a peak base rate in the UK around 4.75%. Now, the market sees 4.5% at the most.

The Bank of Canada announced a "conditional pause" in late January. The market understood that to mean that the tightening cycle was likely over, and subsequent developments have boosted the market's confidence.

At the start of March, the market still thought that another hike was possible, but by the end of the month, the swaps market had discounted a rate cut by midyear. Likewise, the market expects the Reserve Bank of Australia to announce a "pause" at its April 4 meeting, but a cut is discounted for Q4.

The first meeting for the Bank of Japan's new governor is on April 28. The decline in global interest rates has done what massive buying of government bonds failed to do, and that is to push Japan's 10-year yield away from its 0.50% cap. The decline in inflation, driven by energy subsidies, the appreciation of the yen on a trade-weighted basis, and the decline in energy prices, makes action to adjust monetary policy somewhat less urgent.

Still, excluding fresh food and energy, Japan's February CPI accelerated to a new cyclical high of 3.5% from 3.2% in January and 3.0% in December. Changing monetary policy risks disrupting the capital markets even if telegraphed the way officials do. Yet, changing monetary policy when the boundaries are under pressure is arguably more risky than when the yield-curve cap is being challenged.

Emerging markets wobbled with the banking stress in developed economies, but overall finished the month on a firm note. The MSCI Emerging Market equity index recouped about a third of its February losses (~2.2% vs. -6.5%) and outperformed MSCI's developed market equity index (1.6% vs. -2.5% in February). For the quarter, though, the developed market index rose 6%, while the EM equity index rose half as much.

Emerging market bonds pared February's losses, while JP Morgan's Emerging Market Currency Index rose 1.3% after falling nearly 2% in February. On the quarter, it rose by about 2%. Moreover, it rose by 3% in Q4 22, and the back-to-back quarterly gain was the first since H2 20.

The Colombian peso (~5%) and Chilean peso (~4.5%) led most of the emerging market currencies higher. The Argentine peso (~-5.5%), Russian rouble (-3.5%) and the Turkish lira (-1.5%) were exceptions, falling against the greenback.

Most of the G10 currencies also appreciated against the dollar. This was reflected in Bannockburn's World Currency Index (BWCI), a GDP-weighted basket of the dozen largest economies, and its 1% gain, which recouped about half of February's decline. It is the fourth gain in the past five months.

The biggest contributors were the euro (19.1% weighting), with a roughly 2.8% gain, and the Chinese yuan (21.7% weighting), which rose by almost 1%. Brazil's real posted the month's biggest gain (~3.2%), but its share of the index share is only 2.1%.

Sterling's 2.9% gain was a close second, and it has a 4% weighting. Only two components fell in March; the Australian dollar fell by about 0.7% (1.9% weighting), and the Russian rouble fell by around 3.5% (2.1% weighting). 

Although the BWCI finished near its best level for the month, we suspect it may struggle to advance significantly in the weeks ahead. With the banking stress receding, the pendulum of market sentiment may swing back toward greater confidence in a Fed hike in May and reconsider the prospects of a rate cut this year.

The focus may return to the strength of the US labor market and that price pressures remain elevated. Leaving aside the base effect, as last year's increases drop off from the year-over-year measure, the PCE deflator has risen at an annualized rate of nearly 4.5% over the three months through February after a 3.2% annualized pace in Q4 22.

Dollar

Previously, it seemed that market sentiment had swung too hard to a 5.75% or higher terminal Fed funds rate. Now, it seems the market is exaggerating in the other direction. The market leans toward believing that the peak in the Fed funds rate was set with the 25 bp hike to 5.0% in March and has a quarter-point cut priced in by the end of July.

At the end of the year, the Fed funds futures reflect expectations of a rate near 4.60%. At the end of February, the year-end rate was seen nearly 75 bp higher. While it is widely recognized that the financial stress will likely spur a tightening of lending standards, which was already flagged in the Fed's Survey of Senior Loan Officers, the key to the economic impact is the magnitude and duration of restrictions.

Economists seemed to prejudge the banking crisis and estimated the disinflationary result was worth 50-75 bp of tightening. While some survey data for March has softened, we expect the real sector data to encourage more moderate views and strengthen expectations for a soft landing. Nonfarm payrolls (April 7) are expected to have risen by 225-250 thousand in February, while average hourly wage growth may slow.

Meanwhile, consumer price growth is expected to have slowed for the ninth consecutive month on a year-over-year basis. In March 2022, CPI jumped 1%. Suppose it is replaced with a 0.4%-0.5% gain that was reported in January and February. In that case, the year-over-year pace can slow to about 5.5%, the lowest since September 2021, when the Fed first signaled its intention to take away the proverbial punchbowl.

It may matter more to Fed officials that a 0.4% increase would put the Q1 rise above 5% at an annualized rate, twice the H2 22 pace. In addition to the interest rate outlook, the market expectations also diverge from the Fed's in terms of growth. The median Fed forecast puts growth this year at 0.4%. Economists are more optimistic at 1.0%, according to the median estimates in Bloomberg's survey.

However, the Atlanta Fed sees the economy tracking around 3.2% growth in Q1(the first official estimate is April 27), and the economists in Bloomberg's survey project 1% growth. In either case, the forecasts seem to imply significant weakness going forward.

Euro

The euro appeared to take a five-week rally into April. It matches the euro's longest advance since July-August 2020. Most of March's 2.5% rally took place in the second half of the month amid ideas that the ECB would continue to tighten policy after the Federal Reserve ceases. The year-end deposit rate is seen above the current 3% target, while the market is pricing in more than 50 bp of Fed cuts.

The stickiness of Eurozone inflation, especially the core rate, where the preliminary estimate in March was an acceleration to a new cyclical high of 5.7%, and a perceived reduction of downside macro risks, encourage speculation of a rate hike at the ECB's next meeting (May 4). The composite Eurozone PMI moved back above the 50 boom/bust level after spending H2 22 below.

The financial stress did not spur drama in the core-peripheral spreads. Nor did the widespread demonstrations in France weigh unduly on the French-German spread, which traded in about a 10 bp range. The euro traded in a $1.0485-$1.1035 range in the first quarter. Although it approached the upper end in late March, we expect the range to hold in April. 

The following are March 31 indicative closing prices, with the previous shown in parentheses. 

• Spot: $1.0840 ($1.0575).
• Median Bloomberg One-month forecast: $1.0825 ($1.0635)
• One-month forward: $1.0860 ($1.0600). One-month implied vol: 7.7% (8.1%).

Japanese Yen

The dollar recorded a high in Q1 near JPY138.00 amid talk of higher US rates for longer in early March. It peaked on March 8 after having pushed through the 200-day moving average for the first time since last December's Bank of Japan surprise. As the banking stress reached a fevered pace, the dollar trended lower and briefly dipped below JPY130 late last month.

Japanese banks, who also bought low-yielding bonds, were tarred with the same brush that tarnished US and European bank shares. The Topix bank index reached a five-year high on March 9 before plummeting nearly 19% the following week. It stabilized but finished the month off about 11.5%.

The exchange rate correlation (rolling 60-day) with 10-year US rates had weakened to near two-year lows (~0.23) in early March, but it recovered to new highs for the year (~0.55) by the month's end. The Bank of Japan meets on April 28, and it will be the first as governor for Ueda. New forecasts will be announced, which could signal Ueda's intentions. 

The decline in global rates and the sharp decline in Japanese inflation, owing in good measure to the fiscal subsidies for energy, have removed pressure from the 0.50% cap on Japan's 10-year bond. Tactically, it may be best to adjust policy when it is not being tested. Previously, we thought a chance of a move in late April was unlikely, but the changing circumstances create more degrees of freedom for the BOJ's new leadership.

• Spot: JPY132.85 (JPY136.20).
• Median Bloomberg one-month forecast: JPY131.85 (JPY134.40).
• One-month forward: JPY132.20 (JPY135.55). One-month implied vol: 13.0% (12.2%).

British Pound

Through the first quarter, sterling is the strongest G10 currency, rising by about 1.8% against the US dollar. It has been supported by an improved economic outlook. Toward the end of last year, the Bank of England offered a sobering forecast of a prolonged recession. However, by the end of Q1, it was more optimistic and suggested a recession could be avoided. Indeed, the year has begun off on better footing than expected.

January's monthly GDP expanded by 0.3% (rather than 0.1% per the median forecast in Bloomberg's survey). The labor market remains strong. February retail sales jumped 1.2%, well above expectations, and the composite PMI averaged 51.3 in Q1 after averaging 48.5 in Q4 22. Still, it is the only G7 country not to have regained pre-pandemic output.

Prime Minister Sunak scored two important victories in March. First, the new accord on Northern Ireland ("the Windsor Framework") finally gives some closure to Brexit. Second, the UK is set to join the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP), the first new member of the trade bloc. It culminates two years of negotiations.

The direct impact on the UK economy is likely to be minor at best, but the importance is what it signals about the UK's future post-Brexit. The Bank of England does not meet until May 11, and the swaps market leans toward another quarter-point hike, bringing the base rate to 4.50%. That is seen as the likely terminal rate, down almost 25 bp from the beginning of last month.

Sterling has been in the $1.1800-$1.2450 range since the middle of December 2022. We suspect the range will remain intact for a bit longer.

• Spot: $1.2335 ($1.2015).
• Median Bloomberg one-month forecast: $1.2290 ($1.2060).
• One-month forward: $1.2345 ($1.2025). One-month implied vol: 8.5% (9.8%).

Canadian Dollar

The divergence of monetary policy between the Bank of Canada, which announced a "conditional pause" in its monetary cycle in late January, and the Fed, signaling higher for longer, weighed on the Canadian dollar. The greenback reached a five-month high near CAD1.3860 as the financial stress hit. The shift in interest rate expectations saw the US dollar surrender much of its gains and pushed back to almost CAD1.35 at the end of March.

The Canadian dollar has become somewhat less sensitive to the US S&P, and the rolling 6,0-day correlation has fallen to about 0.59, a two-year low (from almost 0.80 in early February). The exchange rate seems somewhat more sensitive to the two-year interest rate differential. The Canadian dollar's correlation with oil prices has eased from almost 0.50 at the end of last year, on a 60-day rolling basis, to around 0.10 in late March.

Although the Canadian economy is more resilient than the Bank of Canada expected, it is still convinced cumulative effects of the past tightening have begun restraining demand. The Bank of Canada meets on April 12 and is expected to keep the overnight target rate at 4.50%. The March CPI is reported on April 18, and the year-over-year rate will likely fall sharply as the March 2022 gain of 1.4% drops out of the 12-month comparison.

• Spot: CAD1.3515 (CAD 1.3640).
• Median Bloomberg one-month forecast: CAD1.3475 (CAD1.3535).
• One-month forward: CAD1.3510 (CAD1.3635). One-month implied vol: 6.7% (7.1%).

Australian Dollar

Even before the banking stress last month, the Reserve Bank of Australia seemed to have been edging toward a pause in its tightening cycle. After the central bank's minutes, softer-than-expected February CPI, and the change in the outlook for monetary policy in the US and elsewhere, the market is more convinced that the RBA will not hike rates at its April 4 meeting.

At the end of February, the market had seen the year-end rate near 4.25%. Now the futures market implies a year-end rate near 3.40%. RBA Governor Lowe's term ends in September, and following a formal review of the central bank, we suspect he will not be offered a second term.

The Australian dollar recorded the lows for Q1 23 on March 10 near $0.6565, holding above the $0.6550 we had thought was possible. That support area is still key. The Aussie's recovery faltered near $0.6760 (March 22-23), where the 200-day moving average was found. Still, a move above $0.6800 would boost confidence that a low is in place and could spur a return toward $0.7000.

• Spot: $0.6685 ($0.6735).
• Median Bloomberg one-month forecast: $0.6760 ($0.6800).
• One-month forward: $0.6700 ($0.6740). One-month implied vol: 11.1% (12.5%).

Mexican Peso

The banking stress and the unwinding of market positioning took a toll on the Mexican peso. However, as the pressure seemed to abate, the peso recovered. The US dollar recorded nearly six-year lows on March 9 (~MXN17.8980) and surged a little over MXN19.23 on March 20. At the end of the month, it was fraying the MXN18.00 level again.

The interest rate differential continues to attract investors, and near-shoring/friend-shoring also favors the peso. Still, the sharp jump in the greenback saw implied volatility soar from below 11% to a peak near 15.4% for a three-month tenor, which was the highest in nearly a year. Still, as soon as there were preliminary signs that the financial stress was easing, the peso strengthened, and volatility softened.

We remain concerned about what appears to be a deterioration of the domestic political situation and growing tensions with the US. Yet, institutional strength, including the central bank and judiciary, continues to be evident and helps underpin the peso.

Therefore, the peso has scope to continue recovering in the coming weeks. It is difficult to talk about support with the greenback at five-year lows, but the next interesting chart points are around MXN17.45 and MXN17.60.

• Spot: MXN18.05 (MXN18.31).
• Median Bloomberg one-month forecast: MXN18.26 (MXN18.50).
• One-month forward: MXN18.15 (MXN18.43). One-month implied vol: 11.5% (10.5%).

Chinese Yuan

Benefiting from the pullback in the dollar, the yuan rose by almost 1% in March after falling 2.6% in February. Although local investors did not appear exposed to the decline in AT1 bonds or western banks, China has its own challenges.

The high-yielding bonds from the property developers suffered their biggest loss in five months. Reports suggest property sales have improved with the aid of government measures, but the underlying problems of overcapacity continue to plague the sector.

The median forecast in Bloomberg's survey sees the world's second-largest economy expanding by 5.3% this year, the same as the IMF. We suspect the risk is on the upside. According to the IMF, China could account for a third of the world's growth this year. Economists estimate that the economy grew by almost 2% quarter-over-year in Q1 (to be reported on April 18).

Beijing appears content to have the yuan track the movement of the euro and yen. The rolling 60-day correlation of the changes in the yuan and yen reached a six-year high in late March (~0.58) and a five-year high against the euro (~0.66).

• Spot: CNY6.8735 (CNY6.9355).
• Median Bloomberg one-month forecast: CNY6.8480 (CNY6.9020).
• One-month forward: CNY6.8560 (CNY6.9300). One-month implied vol: 6.5% (9.5%).

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