Fed is done, traders see as less aggressive Fed

The collapse of two big U.S. regional banks has forced the U.S bond markets to a 180 degree turn from pricing in a more aggressive Federal Reserve and is eroding expectations that the dollar could resume a new rally to fresh 20 year highs.

Emergency measures taken by the Fed and the US government on Sunday to guarantee bank deposits failed to reassure markets after Signature Bank and Silicon Valley Bank collapsed.

The dollar fell from three-month highs after the plunge in short-term U.S. Treasury yields, which were at 15 year highs, was the steepest since October 1987.

Two-year yields fell to 3.939% on Monday, a decline of more than a percentage point from a 15 year high of 5.084% reached last week, while 10 year yields fell to 3.418%, from more than 4% last week.

The move comes as investors rush for safe havens and adjust for less aggressive Fed in the wake of bank failures. The dollar fell 0.60% against a basket of currencies on Monday.

The market is basically saying that the Fed is done, said Mazen Issa, senior FX strategist at TD Securities in New York. It wouldn't surprise me if the market will try to keep pace with the Fed and won't believe any realm of hawkishness that emerges, and it is not clear whether or not the Fed will continue to be hawkish. Fed Chairman Jerome Powell surprised markets last week when he said that the U.S. central bank might increase the pace of rate hikes as it battles still high inflation and benefits from a strong employment picture. Treasury yields went up sharply and boosted the dollar index.

The prospect appears to be off the table.

As the Fed funds futures traders see the Fed as most likely to leave rates unchanged when it meets on March 21 -- 22, or raise rates by 25 basis points, a change from last week after Powell's comments before congressional committees, when a 50 basis points rate increase was viewed as the most likely outcome.

Some banks, including Goldman Sachs and NatWest Markets, have said they don't expect the Fed to raise rates this month.

The Fed funds rate is expected to fall to 3.80% in December, down from 4.57% now, with traders pricing for the Fed to cut rates this year. As of last week, traders had given up on the prospect of rate cuts this year.

Jonathan Cohn, head of rates trading strategy at Credit Suisse in New York, said there were possible heightened recession risks due to the financial stability issues.

While the market may retrace some of Monday's moves, there are these kinds of questions surrounding the provision of credit, of bank lending, that have to be answered before markets are going to price as aggressive of a hiking cycle as they used to be, according to Cohn.

The financial stability risks could affect their view on further tightening, as Fed officials are in a blackout period before the March meeting.

Even if they repeat their commitment to bringing down inflation, investors may not be willing to embrace the message, as they did only last week.

If the market assumption as recently as a week ago was that the Fed can and will continue to hike no matter what, I think it will be very difficult for the market to come back to that view, said Brian Daingerfield, head of F 10 FX strategy at NatWest Markets in Stamford, Connecticut.

He said that that is very important because the resetting of Fed expectations ever higher was a big part of the dollar rally we had seen before these moves.