UBS acquisition of Credit Suisse alleviates some concern, risks remain. AT1 bond concerns will add to bank funding costs, lifting recession odds

By Stuart Talman, XE currency strategist

UBS’s state backed takeover of Credit Suisse has restored some confidence to the market, removing one potential black swan event as regulators, central banks and the biggest banks take steps to shore up the embattled banking sector.

The New Zealand dollar opened higher to start the new week, risk assets responding favourably to the Credit Suisse lifeline in addition to news over the weekend that the Fed and its major central bank peers would adopt co-ordinated action to provide extra money market liquidity.

Commencing Monday near 0.6280, the Kiwi has underperformed, logging a marginal loss. Ranging between 0.6230 and 0.6280, NZDUSD starts Tuesday’s local session near 0.6250.

With key technical resistance at 0.6270 and the 38.2% Fibonacci retracement of the February to March pullback located at 0.6257, the Kiwi trades at the upper bound of a 0.6090 – 0.6270 range that has contained price action over the past 4 weeks.

An upside breakout could occur should turbulence in the US and EU baking sectors subside.

Avoiding a Credit Suisse (CS) collapse is undoubtably good news; however, it has caused negative knock-on effects - markets in uproar over the impact that the takeover had on wiping out CS’s additional Tier 1 or “AT1” debt.

AT1 bonds also known as contingent convertibles or “CoCo” bonds are a biproduct of the GFC and the implementation of Basel III protocols. Regulators require banks to maintain a level of AT1 bonds to act as a cushion in times of financial stress should a bank’s capital levels fall below a certain threshold.

AT1 bonds can be converted to equity or written off and are the riskiest type of bond a bank can issue, therefore carrying a higher coupon (return).

When AT1 bonds are converted, the bank remains liquid, transferring risk away from depositors and taxpayers to investors.

AT1 bonds hold a higher ranking than shares – if the bank collapses, bondholders will receive their money before shareholders.

However, in Switzerland this does not occur in the case of a restructuring, bondholders lose out to the shareholders which is what occurred in the Credit Suisse deal. Whilst shareholders did take a hit, AT1 bond holders received nothing – the bonds were wiped out.

Fixed income investors are understandably in uproar over the Swiss regulator’s decision. The unintended impact - the price of AT1 bonds at other banks falling. Investors are panicking fearing that their bonds may be at risk of the same fate as CS’s CoCo’s.

The implication for the broader market is that heightened investor caution will require a relatively higher yield for AT1 bondholders, thereby increasing bank funding costs, making it harder for banks to raise money and maintain the regulatory required level of AT1 bonds.

Rising borrowing costs will in turn lead to a slowing in economic activity.

Therefore, the steps taken by regulators to avoid banking failures and contain contagion risk likely pushes the global economy into a pronounced recession.

Not good news for risk sensitive assets, including the New Zealand dollar.

Shifting our focus to the day ahead, locally we receive the Westpac consumer confidence survey and trade balance data. RBA meeting minutes are the major regional event for Tuesday.

It’s a quiet 24 hours for offshore macroeconomic data releases, CPI out of Canada being the headline event.

Banking sector headlines and how bond and credit markets behave are likely to be the key factors to influence short term direction.

With the FOMC meeting less than 48 hours away, price action may be subdued as the market awaits the Fed’s most important decision of this cycle.

Market pricing favours a 25bps hike from Powell…..the attention will be on the latest set of quarterly dot plots and Powell’s messaging. Like ECB President Lagarde, Powell likely detaches the ongoing inflation fight from financial stability concerns, implementing a dovish hike whilst conveying confidence that the Fed and FDIC have averted a widespread banking crisis.

Should the Fed refrain from hiking, an on-hold decision may have the effect of freaking out the market, adopting the view that the inflation battle has been abandoned to prop up a banking system on the brink of collapse.

Absent any additional banking shocks or dysfucntional credit markjets, we expect the New Zealand dollar to continue to track sideways in the lead up to Thursday morning’s FOMC decision/statement/presser, ranging between 0.6190 and 0.6280.

Stuart Talman is Director of Sales at XE. You can contact him here.