21.03.2023 09:23 AM
The dollar and financial stress: the main thing is to get up after a knockout

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The US currency has to defend its position, the loss of which threatens its stability. However, USD values are still volatile as the greenback confronts serious financial stress that has engulfed major banks. Meanwhile, the euro also has little room for growth.

Amid problems with Europe's leading banks, market participants returned to protective assets, primarily the dollar. Traders and investors are trying to figure out if the major central banks will be able to contain the impending global financial crisis. In the current situation, the appetite for risk decreased significantly, but after a while it started to gain momentum.

Last weekend, Switzerland's biggest bank, UBS, agreed to buy its ailing rival Credit Suisse. UBS acquires Credit Suisse for $3.23 billion. In addition, UBS will take up losses amounting to $5.4 billion. It is expected that the deal will be completed by the end of 2023. The Federal Reserve will provide important support in stabilizing the difficult financial situation. The U.S. central bank will resume offering daily swaps to the Bank of Canada (BoC), the Bank of Japan (BoJ), the Swiss National Bank (SNB) and the European Central Bank (ECB) to help them with liquidity.

This situation has somewhat diffused the tension in the market and gave a head start to the euro. As a result, the latter overtook the greenback, recouping earlier losses. On Tuesday morning, March 21, EUR/USD was trading at 1.0709 trying to go higher.

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Analysts believe the current state of the U.S. currency is determined by the level of stress in the global banking sector. At the moment, the dollar is taking a hit, but its strength is not infinite. Many experts fear that the whole banking system will be under threat, but these fears are unfounded. According to currency strategists from Goldman Sachs, it is not unusual for the USD to lose ground in times of financial stress. However, if the scale of this stress is serious enough, the situation can get out of control.

According to Goldman Sachs, the 'safe-haven' demand for the dollar tends to vary with the difference between yields on the three-month corporate debt of the banking sector and its 'risk-free' counterpart in the U.S. Treasury market. Dollar strength builds and broadens significantly once the corporate bond spreads rise above 70 basis points or 0.7%, though this is rare. The bank notes that an increase in the financial spread of more than 70 bps strengthens the greenback, and vice versa. The dollar is currently seeking to gain momentum, acting with mixed success. If the current situation worsens, the greenback will have to work hard to stay afloat, says Goldman Sachs.

The Goldman Sachs team also says one important factor that at least partially explains the differing dollar outcomes is the performance of stock markets because the largest and broadest rallies from the greenback have tended to coincide with the steepest losses for share indices. Similarly, when moderating expectations for the Fed interest rate prompt U.S. Treasury yields to fall more than their overseas counterparts.

At the moment, the dollar is under little threat, according to Goldman Sachs. However, intensification of negative trends in world markets could send the greenback to a knockout. Nevertheless, in the coming weeks and months, the greenback will stay afloat, although its strengthening remains questionable.

Against the background of financial stress in the banking system, the current actions of the Fed regarding the interest rate and the prospects of the U.S. economy become relevant. At the moment, markets are waiting for the Fed's decision on these issues after the next meeting, which takes place on March 21-22. "We would most likely face a similar backdrop to just a few weeks ago: an overheated economy that requires another repricing as cuts are unwound and rate hikes are added back in after March," Goldman Sachs summarizes.

At the end of the current FOMC meeting the decision on the key rate will be announced, as well as the current macroeconomic forecasts. Later the markets will focus on Fed Chairman Jerome Powell's speech. Market participants expect signals on the central bank's further plans on monetary policy in view of the difficult situation in the global banking sector.

At the moment, traders and investors are assessing the current measures of central banks aimed at normalizing the financial background. Many experts fear that the existing liquidity problems may be worse than expected. The current market situation is not very favorable for the dollar, as it is pressed by the Fed's dovish stance. This gives the euro a chance to outperform its U.S. rival. From time to time, the single currency enjoys such favorable opportunities. However, analysts think that in the long run, the EUR/USD pair won't be able to benefit from the greenback's weakening if investors keep withdrawing into protective assets and avoid risk.

Larisa Kolesnikova,
Experto analítico de InstaForex
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