The dollar is coming off its worst month since November, when a cooler-than-expected CPI report and excitement over the Fed “step-down” story triggered a reversal of fortune for assets of all kinds.
The ~2% drop was meaningful, and never let it be lost on you that a weaker dollar is a boon for risk assets, all else equal.
All else wasn’t exactly “equal” in March, but falling yields and a back-footed greenback certainly didn’t hurt in terms of the broader equity market’s capacity to ignore or otherwise shake off tumult in the financial sector.
It’s not hard to explain last month’s dollar weakness. The bank failures dramatically reduced terminal rate expectations and put the Fed on notice that additional rate hikes risked financial instability. Financial instability is a total non-starter.
If nothing else, SVB’s collapse meant policymakers would be more careful going forward, even if signs of bank stress receded.
A careful Fed juxtaposed with a somewhat obstinate ECB and a BoJ which may soon pivot under new leadership, is a decent medium-term policy divergence narrative to go along with the immediate read-through of lower US yields.
The dollar’s worst sessions coincided with a historic repricing at the US front-end, and a sharp drop in reals. And then there was the March FOMC meeting.
Certainly, acute meltdowns can be accompanied by dollar strength given that, in a real crisis, there’s only one safe haven. (And for the gold and Bitcoin fans, I’d remind you that in a Chicxulub impactor crisis, there are no safe havens, although if the asteroid hits on another continent, that New Mexico compound might help.)
For the purposes of FX strategy, though, it’s useful to distinguish between i) hair-on-fire panic scenarios where gauges of funding stress go haywire, cross-currency bases dislocate, US reals suddenly spike and the dollar rises and ii) more narrow, idiosyncratic crises like the one witnessed last month. In the latter, a lot hinges on the read-through for policy.
With that in mind, it’s worth asking whether purported “stability” in the banking sector, alongside evidence that the economy isn’t likely to crumble overnight as a result of incrementally tighter lending standards (remember: Lending standards had already tightened dramatically prior to the bank stress, and that hadn’t yet succeeded in undercutting the economy), might soon shift the focus back to some softer version of the “higher for longer narrative,” thereby lifting the dollar.
That’s the context for the short excerpt below from Goldman’s FX team, which I think is worth highlighting:
How long can good news be bad for the dollar? Markets face a growing dilemma. The drumbeat of negative news has slowed. The feeling of “still more shoes to drop” has receded somewhat. Our bank analysts say incoming questions have turned from “who is next?” to “what is the earnings impact?” And yet, Fed pricing has only recovered slightly and the dollar is weakening on this more supportive risk setup. So the question is: If massive liquidity injections have effectively ringfenced the banking stresses, and if the failures were a “textbook case of mismanagement,” as Vice Chair Barr testified, rather than a sign of more systemic issues, then why halt the hikes? In the [March] press conference, Chair Powell said that the new forecasts reflected an assessment that there would be “some tightening of credit conditions, and that would really have the same effects our policies do.” Markets had already come to the same conclusion, and priced less Fed tightening and a worse economic outlook, which is negative for the dollar. But, tightening from what has transpired so far does not appear to be large enough to provide the amount of restraint the market is pricing. The Fed funds rate path through the rest of the year is more than 100bps lower than before the bank failures, and far above our estimate of the impact from a more modest tightening in lending conditions. If the economic fallout remains more modest, and core inflation pressures are cooling only slowly like the February data suggest, then we would expect the next part of Chair Powell’s [press conference] answer to start getting more attention: “…if that [tightening] turns out not to be the case, in principle you would need more rate hikes.” In other words, there is a limit to the extent that “good news” (or at least lack of bad news) can be priced alongside a more dovish Fed.
