While the euro continues to gain ground, the US dollar has not given up yet.
EUR/USD closed the session on Tuesday in positive territory near 1.0765 for the fourth day in a row. It has maintained its bullish momentum largely due to the weakening US dollar.
Closing the trade on Wednesday, the US dollar index fell by 0.08% to 102.85, retesting six-week lows of 102.65 in the course of the session.
The US currency is losing ground as investors expect the Fed to abandon its aggressive monetary policy in order to ease the pressure on the financial system and to pause the tightening for some time.
Such expectations have intensified after the Bank of Australia minutes came out on Tuesday. They pointed to a possible pause in the rate hiking cycle at the next meeting.
"The members of the Reserve Bank of Australia agreed to reconsider the case for a pause at the following meeting, recognizing that pausing would allow additional time to revise economic forecasts," the document says.
According to the RBA officials, rates have already been raised to levels that could contain inflationary pressures but the economic outlook still remains uncertain.
Earlier this month, another major central bank, the Bank of Canada, left its policy rate unchanged. This comes after eight consecutive hikes that have taken the key rate up by 425 basis points since March last year.
The regulator acknowledged that its aggressive interest rate strategy is bearing fruit as inflation has been steadily declining in recent months.
Thus, the annual inflation rate in the country decreased to 5.9% in January from a high of 8.1% recorded in mid-2022
The regulator noted that with sluggish economic growth expected in the coming quarters, demand is projected to decline which is unlikely to lead to higher prices.
The meetings of the Reserve Bank of Australia and the Bank of Canada took place a few days before the collapse of a number of US banks and the collapse of Credit Suisse, which led to its takeover by the Swiss competitor UBS.
According to experts, the tightening of financing conditions in the markets caused by the recent turmoil in the banking sector may have done most of the work of central banks, strengthening the case for an early end to interest rate hikes.
Just a couple of weeks ago, traders priced in a scenario when the interest rate in the US would rise above 6% and above 4% in the eurozone.
Market participants now seem to believe that the cycle of rate hikes on both sides of the Atlantic is almost over.
Investors now see US rates peaking at 4.8% versus the previously expected 5.5%.
In the Eurozone, the maximum rates are projected at 3.25%.
However, according to ECB spokesman Pablo Hernandez de Cos, these market expectations for a rate peak cannot be confirmed.
"Financial market turmoil may do some of the European Central Bank's work for it if it dampens demand and inflation," ECB President Christine Lagarde said, adding that without tensions, she would have indicated the need for further rate hikes.
The head of the ECB apparently meant the reduction in lending and the cooling of economic activity, which may be the result of both higher interest rates and turmoil in the banking sector.
Robert Holzman, a member of the ECB Governing Council, spoke in a similar manner.
He noted that liquidity in the financial system has declined, implying a drop in bank stocks caused by fears of a banking crisis.
"If due to liquidity reduction, inflation in the euro area slows down or deflation starts, then the ECB will no longer have to raise rates, or it will be possible to limit them to a more gradual increase," Robert Holzman said.
Last Thursday, the ECB raised interest rates by another 50 basis points. However, the regulator did not give any indications regarding the upcoming rate changes.
This week, it is the turn of the US Federal Reserve.
Economists at Apollo Global Management reckon the scale of tightening was equivalent to adding 1.5 percentage points to the Fed's policy rate.
"Financial conditions are the tightest they have ever been since the Fed began to increase interest rates," they said.
"Even assuming market volatility does subside over the coming days and weeks, we think some residual tension in financial conditions is likely to persist," experts at ABN AMRO said.
"Given that this will do some of the Fed's tightening work for it, by depressing lending to the real economy, this is likely to reduce the need for further policy tightening. This could also be a reason for US rate cuts this year," they added.
Currently, the futures market expects the Fed to cut its borrowing costs by 60 bps by the end of the year.
Former Lehman Brothers vice president Lawrence McDonald believes the Fed will cut rates by 100 basis points before the end of this year.
In his opinion, the US authorities will need at least $2 trillion to stabilize the country's banking system.
However, even if the US central bank manages to contain financial contagion, lending conditions are likely to tighten more quickly due to pressure from both the market and regulators.
Recent troubles are likely to lead to tighter rules and higher capital requirements for smaller banks, which play an important role in delivering credit to the economy, Goldman Sachs strategists said.
"Some smaller banks will need more capital and the smaller institutions in the US in particular will have to adjust to stricter regulation. As a result, they have become more cautious in lending. This may affect the real economy. Credit is becoming less and less available, which in turn could slow economic growth," they said.
Goldman Sachs estimates that an expected tightening of bank lending standards could reduce economic growth in the United States by 0.25-0.5% in 2023, equivalent to the impact of another 25-50 bps Fed rate hike. However, experts warn that the impact could be even greater.
The recent turmoil in the US banking sector is to some extent the result of a sharp tightening of monetary policy in the country. Obviously, the fundamental problems are much deeper than the problems of regional banks, and they will definitely manifest themselves this year.
Therefore, many analysts consider a "hard landing" of the American economy as the baseline scenario, predicting a recession in the second half of 2023.
Economists at JPMorgan said the inverted Treasury yield curve would meet expectations, signaling a recession to come.
They believe the US economy is headed for a "hard landing" as the recent banking turmoil greatly raises the chance of a recession.
"The Fed has already passed the point of no return, and a soft landing now looks unlikely given the recent market turmoil caused by the collapse of Silicon Valley Bank and the fact that banking problems naturally slow the economy," JPMorgan said.
According to Goldman Sachs, the US dollar will benefit if the banking turmoil spreads to other jurisdictions that are also facing rapid interest rate hikes.
Based on the experience of 2008, urgent action is now being taken and the financial fire is likely to be put out with a massive injection of liquidity, in particular in Switzerland and the US, and more generally around the world.
However, investors worldwide have incurred losses of about $10 trillion from depreciating bonds due to the sharpest increase in interest rates in decades.
The losses can be offset by lowering interest rates, which looks like a difficult task today, given that the fight against inflation has not yet been completed.
In addition, bailing out a bank in a country that has always been a safe-haven bastion of political neutrality runs counter to one of the key lessons of the 2008 financial crisis by concentrating even more risk in banking giant UBS.
In the future, this could seriously affect not only Swiss but also European financial stability.
In such a scenario, the demand for safe-haven assets, which include the US currency, may increase.
So far, the US dollar remains under pressure as the Credit Suisse bailout and moves by major central banks to boost liquidity eased fears that the crisis would spread on a broader basis.
"There is a chance that there will be little impact on this side of the Atlantic, but there is less chance that the United States will come out unscathed. This should prevent and reverse the narrowing of the US vs. European rate/yield spread that we have seen in recent days. And this, in turn, suggests that the euro has the potential to rise against the dollar as the situation calms down and risk aversion disappears," said strategists at Societe Generale.
The current dynamics of EUR/USD indicate that investors are relatively optimistic in assessing the prospects for eurozone banks.
On Wednesday, the main currency pair remained stable. It has already come close to 1.0800, taking advantage of the ongoing dollar weakness.
The greenback remains near six-week lows, trading down more than 0.1% at 102.75 as investors wait for the Fed's monetary policy verdict.
The most likely outcome is a 0.25% rate hike. This is the best option, as a moderate increase in rates will mean a measured reaction of FOMC officials to current economic conditions.
However, in light of the US banking turmoil, some traders suggest that Jerome Powell and his colleagues may leave things as they are at the next meeting.
If the Fed fails to surprise the market, the euro will rise further, according to Societe Generale.
"If today's FOMC meeting manages to keep market expectations where they are, the euro should at least continue its slow upward movement. Raising the Fed's key rate by 25 basis points looks like the most likely outcome. Although we will receive a new dot plot and new economic forecasts, they will certainly be wrapped in vague promises to make it clear that the FOMC is simply buying time to check whether the measures taken to stabilize the banking sector are working," the bank said.
There may be some risk that the markets are overestimating how dovish Jerome Powell's statement may be today, which may contribute to some growth in the dollar in the short term, analysts at Scotiabank believe.
"The main question is how much the statement of the US Central Bank and the press conference of Jerome Powell will change the expectations regarding the final rate (and the expectations of the rate cut at the end of the year embedded in market prices). It seems hard to shake off the idea that the Fed's rate hiking cycle looks very mature which could limit the dollar's ability to appreciate significantly," they said.
As for the EUR/USD pair, a rise above 1.0760 and bullish short-term trend oscillation are giving positive signals for the euro and suggest strong support in case of a decline. The initial support is seen at 1.0750-1.0760 and stronger support lies at 1.0700–1.0725.
"We see some resistance at 1.0835-1.0840, but the pair's advance through the top of the 1.0700-1.0800 range suggests it is looking to retest the 1.1000 area," Scotiabank added.
Meanwhile, economists at Danske Bank remain bearish on EUR/USD, expecting it to fall to 1.0200 in six to twelve months.
"Financial conditions have indeed tightened on both sides of the Atlantic lately, but we think more could happen, allowing us to keep our EUR/USD bearish outlook intact," they said.
But the euro is unlikely to fall below the parity level against the dollar, as it will need fresh energy or rate shocks to return to September lows, Danske Bank said.
"The risks to our outlook are related to the fact that the Fed will change its policy by cutting interest rates. Such a scenario could come true due to fears of systemic risk in the banking sector or a weaker-than-expected economy in the US," the bank said.
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