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A sense of cautious optimism is returning to financial markets this morning as investors bet contagion risks at regional banks in Europe and the United States have been largely contained. All of the major currency pairs are trading within relatively tight ranges, Treasury yields are inching back from last week’s selloff, and equity futures are setting up for a stronger open. Oil prices are rising, gold is falling, and the Canadian dollar – again functioning more like a risk proxy than a national currency unit – is climbing against the greenback.

Signs of stability are returning. European bank shares climbed through the weekend after Friday’s (deeply nonsensical) tumble in Deutsche Bank shares, and sentiment among regional lenders in the US was boosted last night when the Federal Deposit Insurance Corporation said First Citizens Bank would buy most of Silicon Valley Bank, taking on all deposits and loans at the failed lender.

But lasting damage has been done. In an interview with CBS News yesterday, dove-turned-hawk Neel Kashkari said it was difficult to know how turmoil in the banking sector could impact the real economy, but “It definitely brings us closer” to a recession. The Federal Reserve Bank of Minneapolis president said “What’s unclear for us is how much of these banking stresses are leading to a widespread credit crunch. Would that slow down the economy? This is something that we’re monitoring very, very closely”.

Bond markets are convinced of an imminent slowdown. With the Fed expected to begin cutting within months, short-term yields have fallen relative to their long-term equivalents, meaning that the rate curve has begun un-inverting – a phenomenon that often signals a downturn. As Bloomberg’s Joe Wiesenthal put it this morning, “while everyone talks about the inversion as a recession signal… it’s the un-inversion that really precedes each recession”.

Today’s economic calendar is relatively quiet. Bank of England Governor Andrew Bailey will speak at the London School of Economics this afternoon, and testify in front of the Parliament’s Treasury Committee about the Silicon Valley Bank collapse tomorrow. Investors will listen closely for insight into the central bank’s reaction function, given that last week’s decision was not followed by a press conference. With the case for a pause at the Bank’s next meeting well-understood, the pound could gain on any hints of hawkishness.

Things will heat up later in the week, with Friday’s releases particularly likely to trigger market reaction. 

Headline inflation in the euro area is thought to have subsided to 7.2 percent in the year through February, down from the 8.5-percent pace recorded in the prior month as energy prices reverted toward pre-war levels. Core inflation, in contrast, may have climbed by a record 5.7 percent, reflecting ongoing cost increases in the services sector. This certainly won’t achieve the “sustained downward turn in underlying inflation” that European Central Bank president Christine Lagarde says policymakers are looking for, and could support a recovery in monetary tightening expectations.

The Fed’s preferred inflation indicator – the core personal consumption expenditures index – is expected to rise 0.4 percent in February, up 4.7 percent over last year as so-called “supercore” prices (core services excluding housing) keep rising. Ceteris paribus, this would imply stronger odds on an incremental rate increase at the Fed’s May meeting, but the 5.25-percent peak rate embedded last week’s “dot plot” – coupled with Chair Jerome Powell’s suggestion that regional bank turbulence might amount to a 50 basis point hike – should keep expectations relatively stable for now. Personal income growth could decelerate sharply to around 0.2 percent, down from January’s 0.6-percent gain as Social Security cost-of-living adjustments roll off.

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