The dollar rose on Wednesday on safe-haven buying after Credit Suisse's stock tumbled following the disclosure of "weaknesses" in its financial reporting that renewed investor concerns that a full-blown global banking crisis may be brewing.
European currencies fell sharply against the dollar after Credit Suisse shares plummeted after its biggest investor, citing regulatory issues about the size of its holding, said it was unable to increase its stake.
Concerns about the Swiss bank led the European banking index to fall 6.12%, its biggest one-day drop in more than a year, and triggered a sharp decline in European and U.S. bond yields as investors questioned if the Federal Reserve and other central banks can keep hiking interest rates to curb inflation.
"The concern with Credit Suisse is whether or not this is going to turn into a full-blown global banking problem," said Bipan Rai, North America head of FX strategy at CIBC Capital Markets in Toronto.
"It really looks like central banks are caught between a rock and a hard place between tightening policy to address issues in the real economy and then, of course, the spillover effect is the fact that there's a financial side to that."
The dollar index, which measures the U.S. currency against six others, rose 1.1% and the euro fell 1.4% to $1.058. The dollar rose 0.85% against the Swiss franc, while sterling traded down 0.75% at $1.2067. The Japanese yen strengthened 0.75% at 132.22 per dollar.
Fed funds futures, which reflect the overnight rate that banks use to lend to each other, plummeted. The December contract tumbled to 3.62% in a sign markets expect the Fed to be cutting interest rates by year's end, if not before.
Two-year Treasury notes, which move in step with interest rate expectations, slid 42.5 basis points to 3.8%, while the likelihood the Fed does not raise rates at its policy meeting on March 21-22 rose to about 50%, CME's FedWatch Tool showed.
"With the regional banks playing a key role in U.S. credit extension, the Fed will not raise interest rates next week and we have likely seen the peak in both short and long rates during this cycle," said Torsten Slok, chief economist at Apollo Global Management, in a note.
In Europe, money markets also changed their bets on rate hikes by the European Central Bank amid the banking turmoil.
"This morning's Credit Suisse news is doing all of the damage in FX markets as European bank stocks take another beating today," said Simon Harvey, head of FX Analysis at Monex.
"The sell-off in these stocks only raises concerns over financial stability again, which is having a knock-on effect in European government bond and swap markets as the prospect of an more restricted ECB (European Central Bank) comes back into view," he said.
Markets are now pricing in a 60% chance of a 25 basis point hike in euro zone rates on Thursday. Earlier in the day, they were pricing in a 90% chance of a 50 bps hike.
Markets are pricing in a 50% chance of no change and a 50% chance of a 25 bps increase from the U.S. Federal Reserve next week.