Risk aversion appears to be ebbing in financial markets after Swiss regulators forced UBS and Credit Suisse together, and major central banks agreed to increase swap line availability. The dollar is softer, Treasury yields are down, and North American equity futures are stabilizing. We remain convinced that the US and European banking sectors are well capitalized and flush with liquidity, meaning that official policy actions should prove successful in preventing a broad-based meltdown in global financial markets. 

But signs of potential contagion remain obvious: implied volatility levels are elevated, regional bank indices are sitting on losses, and commodities are lower. The safe-haven yen is holding gains, while economically-sensitive currencies like the Canadian dollar are firmly on the defensive. 

In an announcement released last night, the Federal Reserve and five other central banks said that they would switch from weekly to daily dollar swap operations in an effort to “ease strains in global funding markets”. This is a relatively modest step—with smaller implications than the opening of lines that was conducted during global financial meltdowns in 2008 and 2020—but demonstrates a level of concern among policymakers around the possibility of a seize-up in interbank funding markets as deposit flight interacts with a rise in cross-border lending risks. 

Increases in swap line availability are most often accompanied by a soaring dollar—the Fed typically opens liquidity facilities in order to ease global demand for the greenback—but also tend to portend exchange rate weakness ahead as Fed rate expectations fall. We’re not sure that will be the case this time: the trade-weighted dollar hasn’t undergone rapid appreciation in the last two weeks, cross-currency basis swaps are not pointing to any obvious shortage of dollars in international markets, and several Fed rate cuts are already priced in for this year. 

Markets are placing circa-60-percent odds on a quarter-point move at Wednesday’s Fed meeting—and we are still of the view that a hike is most probable—but with ongoing market turmoil likely to have disinflationary effects on the overall economy, the likelihood of a pause is growing. It’s difficult to assess the degree to which troubles in the regional banking sector have contributed to a tightening in financial conditions, but lending activity is almost certainly suffering a sharp contraction (exacerbating weakness that was already emerging), and the psychological impact on business and consumer sentiment could drive a steep contraction in aggregate demand. Policymakers, who have access to a raft of real-time indicators not visible to most market participants, could opt to join their Canadian counterparts in taking a wait-and-see approach. 

The Bank of England is also expected to deliver a quarter percentage point hike at Thursday’s meeting, but an jump in monthly inflation, or a renewal in overall market volatility, could upset the delicate balance of opinions on the Monetary Policy Committee. Wednesday’s data is expected  to show headline and core measures recovering from January’s tumble, but a range of other indicators are pointing to a gradual easing in price pressures. Officials have generally tried to keep the Bank’s inflation and market stability objectives separate—by simultaneously raising rates and buying bonds last autumn, they provided a template for other central bankers to follow now—but growing downside risks could peel off some centrists, convincing them to join Silvana Tenreyro and Swati Dhingra in voting for a pause.