Asia open: Cauterizing extreme stress in the banking sector

Markets

US stocks are trading markedly higher Monday even as investors remain nervously focused on the US banking sector following UBS's announced acquisition of CS over the weekend and ahead of Wednesday afternoon's scheduled March FOMC meeting statement. After last week's volatile market activity, discussions are concentrated on the banks, the Fed, and the breadth of positioning.

With S&P 500 in positive territory coupled with the additional fact that implied volatility is falling back to nearly unchanged from where it was marked before this storm hit, the pattern suggests the market has mostly ringfenced, if not cauterized, the bleeding and extreme stresses in the banking sector.

And what is becoming unhurriedly apparent is there is little less tension around the banks but a lot of anticipation on the Fed meeting this week and probably a fair amount of repositioning as money managers assess the fallout from last week's volatile swings in stocks, bonds, credit, and commodities.

But given the uncertainty in US Regional Main Street Banks, who do the bulk of the heavy lifting in consumer, small business and agricultural loans across America's heartland, there is a good chance the Fed prioritizes stability over inflation this meeting. And with oil tanking in Q1, the inflation problem could look relatively less urgent for this meeting.

While the street can debate local relevancy given everything else that's happening, CPI didn't cement expectations for this week. The good news is that the headline has fallen for eight consecutive months; the bad news is that 5.5% on the core is still far from the target. To be clear: US inflation is still a serious issue, and it's not coming down as fast as most expected (particularly regarding "super core"). That said, I will leave the handicapping to market pricing rather than opinions where quantified recognition of a 25 bp call is fading. Still, I can't remember a time when each distinct scenario carried a reasonable near-term delta.

While measures of dollar funding stress, such as the FRA-OIS basis, have increased. Still, spillovers into offshore dollar funding markets have been relatively limited, and the overnight funding market remains flush. Hence one of the most significant sources of market stresses, the safe-haven demand for the USD, has not come knocking on beatdowns door.

European AT1 instruments have been under pressure, but senior credit in banks – arguably a better measure of systemic risk – has not sharply widened. The market is still not treating recent developments as a systemic event that challenges solvency.

Financials are among the top 3 performing sectors at US Midday-- highlighting a nascent sentiment rebound in today's trading.

As expected, traders are selling VIX( -4.5 %) volatility after the multiple levels of policy balm were heavily layered across multiple jurisdictions. And when taken together with the genuinely stunning drop in front-end yields, there was more than ample kindling for the recovery rally to take flight, notwithstanding a strong chance of a Fed pause in March. But a rate cut sooner than later forms the basis of a recovery rally view.

Oil

With broader levels of volatility easing and the odds of a Fed pause increasing, oil markets recovered from what could have been a negative gamma event as the viciousness of yesterday's Oil market selloff appeared well overcooked, especially in light of China's booming demand.

Still, those rising near-term recession concerns and an exodus of investor flows after a VAR-driven liquidity shock, which likely exacerbated the selloff, still require monitoring.

And with markets turning excessively pessimistic about the outlook( Still big CTA shorts), any supply disruption, like the Kuwait oil spill and the subsequent state of emergency declared yesterday, will trigger significant reversions.

But ultimately, the path to recovery into Q2 will depend on China's continued reopening and OPEC+'s production strategy.

Gold

"Panic in CoCo Park" drove feverish demand for gold yesterday, but perhaps some Fed uncertainty, with US 2-year yields up, has tempered the fever. Still, with the magnitude of global banking backstops settling in, some of the heat has come off the bullion rally. But gold should still shine in this complicated mess of higher inflation and lower growth that policymakers have dropped on us.

Forex

Financial stability concerns have so far weighed on the Dollar, as global markets have treated it primarily as a dovish Fed shock. If the spillovers remain contained, the rapid pricing of cuts will need to be reversed, although it is improbable we will return to early-February pricing. The financial stability risks and potential for rapid credit tightening should keep the Fed more cautious.

FX traders worry that another Fed hike would hinder simultaneous efforts to shore up the financial system. Considerable uncertainty remains, and while no one expects a flat-out Fed "dovefest" to be sustainable, the recent developments have probably crimped the right tail of the Dollar distribution.