The U.S. dollar regained its stability while the euro weakened in early trading on Tuesday in Europe, as the shock from the collapse of three U.S. banks in a week began to recede. The signs of stress in the U.S. financial system have caused a sharp reappraisal of the outlook for interest rates across the U.S. and Europe since Thursday, with two-year yields in the U.S. falling by the most in any three days since the 1987 market crash.
Previously, there was a general consensus for a 25 basis point rate hike from the Federal Reserve next week, with 50 basis points seen as the next most likely outcome. However, most of the market now expects no change, and analysts at Nomura went as far as to predict the Fed will cut the target range for fed funds by 25 basis points.
The collapse of three small U.S. banks – one of which was the first to fail in the country since 2017 – is causing widespread anxiety about the wider health of the banking sector. The fear is that the banking system could be under-capitalized in the event of a major downturn, and there is also concern about the potential impact on economic growth.
The banks’ collapse has led to a wave of investor risk aversion, with demand for U.S. dollars surging to its highest since mid-December. This has caused a negative euro/dollar cross-currency basis swap spread, reflecting a pickup in demand for hard cash.
The situation has led to a reassessment of the outlook for interest rates, with markets now predicting no change in rates, or even a potential cut. This could have significant implications for investors, as it could lead to a shift in the relative value of currencies and create new opportunities for trading.
While the recent collapse of small U.S. banks has caused widespread anxiety, there is some reassurance to be taken from the fact that the U.S. banking system is much more robust than it was in the run-up to the 2008 financial crisis. The Federal Reserve has also signaled its willingness to act to support the economy and the financial system if necessary.
However, the situation highlights the potential vulnerability of the banking sector, and the need for careful regulation and monitoring to ensure that banks are adequately capitalized and able to weather any future economic storms. The collapse of the three small U.S. banks is a reminder of the importance of vigilance in ensuring the stability of the financial system, and the potential risks that can arise even in apparently stable times.