Dollar Retreats As Banking Crisis Weakens Fed's Inflation Combat

fed jan11 27mar23 lt

The banking crisis that erupted over the past fortnight or more in the U.S. continued to disrupt currency market equations globally in the week ended March 24. The crisis that called into question the efficacy of rapid rate hikes to combat inflation has forced the Fed to revisit and reprioritize the goals of financial stability and price stability.

Fears that a banking crisis-led credit crunch could herald an early recession culminated in the Fed, toning down its rate rhetoric as well as rate action in the recent review. The Fed acknowledged that the recent developments in the banking sector could result in tighter credit conditions for households and businesses that could weigh on economic activity, hiring, and inflation. The Fed's dovish commentary, the mild 25-basis points rate hike as well as hints that rate hikes were nearing an end resulted in the Dollar weakening against major currencies over the course of the past week.

The Dollar weakened against the euro, British pound, Japanese yen, Swiss Franc and Chinese Yuan but appreciated against the Australian Dollar and the Canadian Dollar. The Dollar Index or DXY which measures the Dollar's strength against a basket of currencies comprising the euro (57.6% weight), British pound (11.9% weight), Japanese yen (13.6% weight), Canadian Dollar (9.6% weight), Swedish Krona (4.2% weight), Swiss franc (3.6% weight), declined over the course of the week.

The Dollar Index which had closed at 103.71 on March 17 edged up to 103.86 on Monday but shed more than half a percent over the week, to close at 103.12 on March 24. From the weekly high of 103.96 on Monday, the DXY steadily dropped, touching a low of 101.92 on Thursday, before rebounding on Friday, as fears of a banking crisis contagion into Europe dragged down the euro.

The EUR/USD pair which had finished trading at 1.0666 on Friday, March 17 dropped to a low of 1.0631 on Monday. The pair then went on to rally all the way to a seven-week high of 1.0931 by Thursday, before worries about Deutsche Bank saw the common currency reverse gains. Sentiment for Euro was dampened as concerns emerging from the rising costs of insuring bonds of Deutsche Bank triggered a sharp fall in the share price of the German banking major. The pair finally ended at 1.0759 on Friday, gaining 0.87 percent in a week's time.

The pound sterling appreciated half a percent against the U.S. Dollar over the course of the past week. The GBP/USD pair increased to 1.2230 on March 24, from the level of 1.2175 a week earlier, after touching a weekly low of 1.2167 on Monday and a seven-week high of 1.2344 on Thursday. The Bank of England had on Thursday raised rates by 0.25 percent and left the door open for more rate hikes should inflation persist. Data released on Wednesday that showed a surge in inflation and data released on Friday that showed a surge in retail sales kept rate hike expectations alive and supported the pound sterling. Gains were however capped by reports that UBS and Credit Suisse were under a U.S. Justice Department probe regarding help given to Russian oligarchs to evade sanctions.

The banking crisis in the U.S. and the fears of it spreading to Europe benefited the safe haven Japanese yen. Amidst the yen's strength, the USD/JPY pair dropped to a 6-week low of 129.65 on Friday, During the week, the pair decreased 0.83 percent, falling to 130.69 on March 24 from the level of 131.79 a week earlier. The week's high of 133.01 was on Wednesday.

The U.S. Dollar strengthened around 0.75 percent against the Australian Dollar in the week ended March 24. The minutes of the meeting of Reserve Bank of Australia released in the beginning of the week had shown that the RBA was more than willing to pause on its policy tightening cycle in April. The AUD/USD pair finished at 0.6645 on March 24 versus 0.6695 a week earlier. The pair had touched a high of 0.6760 on Wednesday and a low of 0.6625 on Friday.

The projected trajectory of the banking crisis continues to guide the currency market movements. Currency market equations have also been redrawn amidst the Fed jilting its hawkish tilt, exacerbating the monetary policy divergence between major economies. The DXY is currently at 102.92. The EUR/USD pair is currently at 1.0783 whereas the GBP/USD pair is trading near 1.228. The USD/ JPY pair has increased to 131.37 whereas the AUD/USD pair has moved to 0.6651.

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