The market is gearing up for a “dovish” Fed and that is a strong headwind for the Dollar

Outlook: Today we got German ZEW sentiment and will get US home sales and Canadian inflation. At a guess, all will fly by the radar unnoticed.

We have a sudden calm now that we have the fate of two huge problems, USA regional banks and Credit Suisse. One lesser issue remains, First Republic, but Jamie Dimon is on it.

We know calm is returning because the regional banks stocks are up, the UBS equity price is up, and the rate-sensitive 2-year note is almost back to where it was a week ago. Best of all, the CME Fed Watch tool has the probability of a 25 bp hike tomorrow back at a high 86.4%. And gold is retreating.

You never know whether it’s the eye of a hurricane or this is really over. Even if almost over, it leaves questions to be resolved about how to deal with regional banks and the moral hazard issue of whether a big bank is ever too big to fail. There will be new regs—and court cases. And the worth of short-sellers may become evident as the news spreads that a short-seller warned the Feds back in January that Signature Bank was taking too much risk (FT). We agree with the point of view that while some short-sellers are scum, some provide valuable research that targets outfits that really should get taken down. That Robin Hood experience twisted the role of short-sellers, who can actually be noble.

One thing is for sure—banks of all sizes are going to pull in their horns and offer a lot less credit to households and businesses large and small. This includes mortgages and stay-alive loans. We can probably expect a bankruptcy or two. The quality and pricing of collateral for loans is going to get better scrutiny.

Depending on how much firms rely on bank lending to maintain their businesses, employment may suffer. Job losses are what the Fed seeks, of course—and up to about 2 million—to tame inflation, but popular hatred of banking institutions pubic and private is only going higher. Depending on how many jobs are lost, attention can turn to the point of view that it was supply chain blockages, the Covid handouts, and the Ukraine war behind inflation, and raising rates does nothing to address those. This is the lefty, Elizabeth Warren point of view and not terribly popular, but has more than a kernel of truth.

The Fed has to raise rates by the advertised 25 bp tomorrow if only to prevent any whiff of fear that the banking crisis is not over. But the Fed can see lending contraction and falling employment, too, so then the question becomes whether Mr. Powell hints at a pause from here. Not forward guidance, just a hint.

It almost doesn’t matter whether he hints or not—the market is gearing up for a “dovish” Fed and that is a strong headwind for the dollar. Meanwhile, the most popular currency is sterling (who would have thunk it?), in part because the budget was okay, a little weird but okay, and the banking sector is weathering the storm just fine, thank you.

The BoE meets Thursday and the odds of a final 50 bp are still the favored stance. Catch that word “final.” We have the RBA, RBNZ, ECB and Canada whispering about a pause. If the US and UK follow, there might be a free-for-all in FX, or at least focus on data and issues other than central banks and their rate intentions. One thing is likely—the stock markets will love it.

Forecast: The Fed will hike but whether said out loud or not, a dovish pause will be assumed. It won’t take long for that to turn into a pivot and those expecting a cut before year-end will be back in force. Regardless of what other central banks do, this will weigh on the dollar. 

Tidbit: The press and pundits are coming down hard on banks, saying silly stuff like banks are always doomed to fail (short-term liabilities, long-term assets) and the US authorities did everything wrong (from the former head of the FDIC, no less).

But two points: banks are the place where you put the money you are not using at the moment and you are counting on the bank to keep it safe. In medieval Amsterdam, it was a tough guy sitting on a locked wooden chest, with your money inside, at the top of a long, narrow staircase.  The sacred job of a bank is to keep your money safe and give it back upon demand. Period. Investing in loans or securities is a secondary activity, not a sacred duty. The bank could just charge a fee for providing “security” for your money. (It wouldn’t have much by way of earnings if it did.)

Point two: the authorities in the US and Switzerland may have done a bunch of things wrong. Bondholders at Credit Suisse are ticked off that equity holders were saved and they were not, which violates the traditional order of things (but was specified as a possibility in the contract). But the authorities were scared out of their minds. Terrified. Almost paralyzed with fear. If there were a widespread run on the banks, all 14,000+ of them, the US economy would shudder to a halt in three days flat.

There is a little remorse in there, too—the central banks printed a LOT more money than they should have under prudent management. Granted, it was an antidote to Covid. But still.

Tidbit: The Swiss decision to let the AT1/Coco bondholders take a full hit while shareholders kept their holdings was a bombshell; in that portion of the European bond market, which is a messy place to begin with. Apparently those special bonds always did have language in the issuance contract that allowed for exactly this outcome, but nobody reads those things. Yesterday the EU bond markets were in turmoil over the issue, but now the Bank of England and European Central Bank have stepped forward to say their  AT1 bonds are senior to equity and Switzerland was its own unique case.

Tidbit: Reuters reports “Credit Suisse and UBS could benefit from around 260 billion Swiss francs ($280 billion) in state and central bank support, a third of the country's gross domestic product. The aid comes in the form of 250 billion in liquidity which will be repaid, while the government will absorb up to 9 billion in losses from the deal.” Politicians are livid, saying the new combined bank is just too big for the size of the country.

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