SVB and Forex: Dollar Drops in Reaction to Bank Failure

The market's response to SVB

The dollar had been on an upward trajectory last week, pushed to a new high for the year by Fed Chair Powell's hawkish testimony to Congress. Futures markets were pricing in a 50 basis point increase in interest rates at next week's FOMC meeting. On a technical basis, the dollar was extremely overbought and the treasury market (2 year trading above 5% yield) was equally oversold. The news about SVB was the spark that ignited a very combustible mix. Treasuries had the biggest three-day rally since 1987, and the dollar dropped sharply.

Why this time was different

The typical market reaction to a “risk-off” situation has been to buy dollars. The dollar has traditionally been viewed as a “safe haven” during chaotic periods. This time the dollar sold off, mainly for the following reasons:

• Markets were overextended. The dollar had risen for four of the five previous weeks and was at a fresh high for the year when the SVB story hit the newswires.
• Forex markets suddenly anticipated a high probability of the Fed keeping rates unchanged to relieve pressure on the banking sector. By Wednesday, Fed Funds futures showed a 43.5% chance of no rate increase at next week’s FOMC meeting. Based on the CME Fedwatch tool, there is 0% chance of 50 bps.

Currencies gaining the most against the dollar

• The Japanese yen rose for several reasons. Japan continues to keep rates low, so their banks are not experiencing problems adjusting to higher interest rates. Also, Japanese institutions are large holders of US treasury bonds, and bonds moved sharply higher during the crisis. The yen gained about 3% against the dollar between Thursday and Monday.
• The big winner was the Swiss franc, gaining nearly 4% in three days. The dollar went from the year's high to a retest of the year’s low against the franc.

Takeaways: There have been warnings for months of the potential for damage to the financial system due to the rapid rise in interest rates over the last year. Many analysts had been expecting “something to break” as financial institutions tried to cope with a radically changed interest rate environment. SVB’s vast holdings of interest rate-sensitive bonds made them particularly vulnerable to losses when the Fed raised interest rates. More cracks in the system could easily occur in the near future.

The collapse of SVB was a single event, but the reaction to flee the dollar may indicate a shifting global financial system. Macroeconomists have long been expecting a diminishment of the dollar’s role as the world’s reserve currency. Any such change will likely be incremental, but it’s time for businesses to be ready to adapt to new conditions. That means a comprehensive analysis of currency risk and contingency plans for various outcomes.

Higher interest rates are here to stay. Fed Chair Powell has reminded the world that extinguishing inflation is his number one priority, repeating the phrase “higher for longer” multiple times in public appearances. Higher rates mean more volatility in forex markets. Historically, the unpredictability of FX volatility has wreaked havoc on business’s revenue and bottom line.

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