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Everything, Everywhere, All At Once

Much like last night’s Oscar winner, the financial markets appear to be exploring every possibility in the multiverse this morning. Major equity indices are oscillating between gains and losses, global bond yields are plummeting, and currency markets are exhibiting flight-to-safety dynamics after authorities stepped in to unwind Silicon Valley Bank and backstop deposits across a US banking sector that is experiencing losses on its long-dated bond holdings.

In a joint statement released before Asian trading began, the Federal Reserve, Treasury and Federal Deposit Insurance Corporation said that depositors in the collapsed institution would have access to their funds from today, with any losses borne by the banking sector as a whole. To avoid the optics associated with a “bailout”, the senior management team was fired, and investors in the bank will likely suffer a near-complete loss of capital. To support other institutions with underwater long-duration assets, the central bank created a “bank term funding program” that that will value government-backed bonds at par and use them as collateral in exchange for one-year loans.

Equity futures initially jumped on the news as markets bet this action would reduce the likelihood and severity of runs on other banks—while also weakening the case for further Fed hikes—but these gains are quickly unwinding as investors look for the next shoe to drop. Banks are coming under pressure globally, with European financial sector indices dropping, and shares in First Republic, another San Francisco-based bank, falling almost 70 percent in the pre-market after it said it would raise capital from JP Morgan and the Fed’s new backstop plan to bolster its balance sheet.

Bond markets are also experiencing extreme turbulence, on par with some of the biggest moves in modern history. Yields on two-year Treasury notes are heading for the sharpest two-day tumble since 1987, and German rates look set to end the session with the most violent drop on record.

Odds on a half-percentage point hike at next week’s Fed meeting have fallen below 10 percent from the above-70 levels reached during last Tuesday’s Congressional testimony from Jerome Powell. We think the balance of evidence still points to a quarter percentage point hike, but an updated forecast from consensus bellwether Goldman Sachs shows policymakers remaining on hold at the meeting, choosing to avoid rate hikes until systemic risks subside.

With the old aphorism about the central bank’s reaction function—that it raises rates until something breaks, and then begins cutting them—playing out in the financial sector, traders now think the Fed Funds rate will peak near 4.8 percent, dramatically below the 5.7 percent that had been expected on Thursday. 

The greenback is down roughly half a percentage point, falling as yield differentials tilt against it, and the yen and Swiss franc are rallying. The Canadian dollar is (somewhat remarkably, given vast vulnerabilities in the country’s household sector) up slightly on the day. Commodity prices are sliding across the board.

Against this backdrop, the importance of tomorrow’s inflation report has diminished, with an above-forecast print less likely to prompt a wholesale upgrade in rate expectations. As it stands, markets are prepared for a 0.5-percent increase in both the headline and core consumer price indices, which would mark a modest deceleration from the pace set in January.

The European Central Bank will almost certainly raise its inflation forecast and lift rates by half a percentage point on Thursday, but could turn less rhetorically hawkish as policymakers assess a worsening global risk environment.

We think concerns about the US banking sector are overwrought (and at least partially meme-driven) ,but from a broader perspective, it appears that the “variable and lagged” effects of monetary policy are beginning to show up in the real world. If this bout of turbulence worsens and begins to impact consumer confidence in the major developed economies, investors could rapidly pivot from inflation concerns to growth worries – and another round of traumatic adjustments could unfold in currency markets. If so, we wouldn’t bet against the dollar – it often gets sold in the first days of a crisis, but tends to climb back as growth prospects fall in other countries.

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