ECB Leading the Fed into the SVB, Credit Suisse Minefield

The European Central Bank will be the first among its major peers to enter the bank crisis minefield, trying to stay in the fight against inflation after the collapse of SVB and jitters at Credit Suisse.

• ECB leads with rate decision as markets digest SVB collapse, Credit Suisse stress
• Rate hike expectations fizzle as traders price in a quick end of the inflation fight
• The Euro is at risk and may be setting a path to revisit parity with the US Dollar

ECB in the lead as policymakers face credit stress, inflation

The European Central Bank will have the dubious honor of being first among its peers to wade into the minefield following the collapse of SVB and jitters at Credit Suisse. President Christine Lagarde and company are due to issue a monetary policy announcement where – until just days ago – they were all set for another jumbo 50-basis-point interest rate hike. Officials all but pre-announced the move at their last conclave in early February.

The markets no longer expect follow-through. The priced-in outlook reflects a more modest 25bps increase, with the probability of larger move a meager 14 percent. The tightening cycle is now seen peaking with the benchmark deposit rate at 3.25 percent, a climb-down of 75bps just in the past week. That’s after Silicon Valley Bank (SVB) collapsed in the US and panicky markets fearing contagion found a familiar boogeyman in Credit Suisse.

While the details of these two episodes are very different – so much as to be opposites in some respects – the fundamental issue is the same: liquidity.

SVB sought to boost profits by investing a giant inflow of deposits into longer-dated bonds. When the Fed launched the fight against inflation, rising rates pushed those bonds down in value as depositors came for their cash on mass. There was not enough of it there to give them. By contrast, a litany of scandals at Credit Suisse drained it of deposits, making the whole enterprise more vulnerable as rate hikes made sourcing capital expensive.

Data source: Bloomberg

Central banks between a rock and a hard place

So, it is no wonder that the markets now think that central banks will abandon the inflation fight, lest they capsize the global financial system. Priced-in rate hike projections have broadly withered. That would be a hard pill to swallow for authorities whose mandates demand inflation near 2 percent, but who are still faced with much higher readings – most recently, 8.6 percent in the Eurozone and 6 percent in the US.

The line that Ms Lagarde must walk is ultra-fine. If she appears too dovish, inflation expectations may surge as the Euro drops. Runaway price growth will then threaten to derail growth and bring recession. If she is seen as too hawkish, shell-shocked investors may conclude that more bank crises are in the offing, pulling their money from everywhere but the most giant institutions and feeding a self-fulfilling credit squeeze.

The ECB gets to have a go at managing this delicate balance just as investors anxiously await next week’s Fed rate decision. Whatever European central bankers can muster is likely to be extrapolated into expectations for what Chair Jerome Powell and the FOMC rate-setting committee will attempt in turn. That is likely to amplify the markets’ reaction to what Ms Lagarde’s Governing Council delivers, one way or the other.

Sovereign risk adds a further dimension. The pick-up in credit stress has brought with it the dreaded widening of the bond yield spread between Germany – considered the Eurozone’s model of fiscal responsibility – and debt-laden Italy. Financial conditions have tightened as markets quake and lenders hoard cash, which has revived insolvency fears in southern Europe. Italy is both the largest and arguably slowest to deal with its debt load among the troubled member states.

Data source: Bloomberg

The Euro in the crosshairs

In all, this seems to bode ill for the Euro. If the markets come away from the ECB meeting thinking that officials have turned soft on inflation, the currency is likely to fall as capital flows out in search of better stores of value. Alternatively, the sense that policymakers are focusing too much on prices and run the risk of ruinous over-tightening may bring broad-based risk aversion. This too may push the Euro lower against the more safety-minded US Dollar.

The 6E future tracking that exchange rate now appears to be carving out a bearish Head and Shoulders (H&S) pattern on the daily chart. A convincing break below the neckline at 1.0529 would confirm the setup, implying a measured move lower toward the parity threshold (where the Euro and the US Dollar trade 1-to-1). Invalidating the pattern seems to demand that the single currency re-establish a foothold above 1.0840.

Ilya Spivak is the Head of Global Macro at tastylive, where he hosts Macro Money every week, Monday-Thursday.