Calm markets mask USD weakness in the wake of policy divergence

“There are decades where nothing happens; and there are weeks where decades happen.”

Following the market chaos over the last two weeks, a relative calm has beset the markets. Risk sentiment has recovered as fears over the health of European lenders have abated, and the EUR/USD has rebounded as a result. But the outlook for the USD remains uncertain as markets focus on monetary policy divergence in Europe and the US.

The sell-off triggered by the sudden collapse in Deutsche Bank’s share price at the end of last week seems a world away now. Though that now appears to have been caused by the unlikely combination of a single credit-default swap trade and VERY nervous markets.

The sudden calm in the markets has offered a chance for traders to take a view of the wider fundamentals at play here. As I said in my video following the FOMC meeting last week, the main story now is going to be the divergence in monetary policy from central banks on both sides of the Atlantic.

With the European banking sector in apparent turmoil last week, we saw a rebound in the USD. Now with the markets satisfied with the health of the EU’s banks, traders have again focused their attention on interest rates and the different directions being taken by the Federal Reserve and the European Central Bank.

The Federal Reserve has stepped back from its hawkish narrative – the sudden collapse of SVB and the ensuing turmoil forced the Fed to hike rates by a smaller-than-anticipated 0.25%. Although Federal Reserve Chairman Jay Powell pointed to continued uncertainty over the impact of the banking crisis, he did say that “it’s also possible that this will contribute significant tightening in credit conditions over time. And in principle, that means that monetary policy may have less work to do.”

Meanwhile, the European Central Bank raised interest rates by 50 basis points, and bank President Christine Lagarde said, “we are not waning on our commitment to fight inflation, and we are determined to return inflation back to the 2% target in the medium term. That should not be doubted.” Her comments were echoed by Bank of England Governor Andrew Bailey, who pointed out that inflation remains the key focus for the BoE.

The split in the narrative has softened support for the USD, and the EUR/USD has bounced back strongly, though it is experiencing serious resistance at the 1.083 level.  But with no end in sight to tightening from the ECB and uncertainty continuing to cloud predictions over the Fed’s next move, the downside to the EUR/USD will be limited.

Notably, many analysts are advocating a cautious approach; volatility remains high across all markets. Last week, two-year Treasury yields moved more than 10 basis points for 11 sessions in a row, a run of wild swings not seen since 1981. Among these sessions, seven were up and four down. And in the equity markets, the gap between the highest and lowest year-end target for the S&P 500 is 47%, the widest at this time of year in two decades, data compiled by Bloomberg shows.

Markets may be calmer today, but the jitters remain and - as the Deutsche Bank debacle showed us last week - it won’t take much to trigger another round of volatility.