Fed Fine Tunes Rate Policy And Other Central Banks Expected to Follow

 | Jul 02, 2021 12:37AM ET

After falling in April and May, the US dollar rebounded in June, gaining against all the major currencies. The move appeared to begin as a technical adjustment to positions after the two-month slide left the greenback over-extended. However, it morphed into a powerful short squeeze after the Federal Reserve moved into a more hawkish direction. At the March FOMC meeting, the median view was for no hike until after 2023. The June forecasts showed the median projection anticipates two hikes in 2023, and seven of the 18 officials think a hike next year will be appropriate.

The US 10-year yield spiked to a three-month low near 1.35% a few days after the FOMC meeting concluded but averaged around 1.50%, which is still the lower end of the range since the end of February. The shorter end of the curve was not as stable. The December 2022 Eurodollar futures contract (three-month deposit rates) rose from around 33 bp in the first half of the month to 55 bp before the end of June. The cash market set a record low, a touch less than a dozen basis points in mid-June. The futures market implies that a full quarter-point hike is discounted by the end of next year and around 60% of a second hike.

In June, US 10-year yields fell more than in Europe and Asia. Australia, which has ordered a lockdown covering areas that contain around 80% of its population, was the sole exception. Its 10-year yield fell 18 bp compared with the 14 bp decline in the US. The short end of the curve was a different matter. The US 2-year yield doubled to 28 bp, its highest level since April 2020. The premium over Germany rose 10 bp to a new high for the year near 93bp. The premium over Japan rose about the same, and at 37 bp, the premium is the most since early Q2 20. The US two-year premium over the UK rose toward 20 bp late last month, a five-month high. 

Do not get the wrong idea. The US is not in the front of the queue for adjusting monetary policy. Among the high-income countries, Norway fine-tuned its forward guidance and has signaled a rate hike is likely in September. Judging by the participation rate and the number of jobs created in recent months, Australia’s labor market fully recovered from the pandemic. The Reserve Bank of Australia meets on July 6. It is likely to stop its yield-curve control efforts to cap the April 2024 yield at 10 bp, the same as the cash rate. This would entail not extending the target to the November 2024 bond. It seems less clear what the RBA will do with its asset purchases, but it appears likely to slow the purchases from the current A$100 bln six-month pace.

The Bank of Canada is also in the queue. It has begun to slow its bond purchases, and additional tapering could be announced at its July 14 meeting. It is a close call after employment fell in April and May. A strong jobs report on July 9 could help solidify expectations for additional tapering. The market appears to be pricing in a hike in H1 23. New Zealand and the UK are also likely candidates to be in the first group of high-income countries to adjust monetary policy. 

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The European Central Bank, the Bank of Japan and the Swiss National Bank are expected to lag behind the US. However, the ECB’s acceleration of its emergency bond-buying is up for review in September. It will meet a little before the Federal Reserve, which is widely expected to formally announce slowing its purchases in the fourth quarter, perhaps initially focusing on the Agency mortgage-backed securities. The ECB will face an accelerating economy as the vaccine has made possible the uneven lifting of social restrictions and significant doses of fiscal stimulus. Price pressures also will remain elevated as the base effect peaks. 

Time is not a luxury that an increasing number of emerging market central banks experience. Mexico, Hungary, the Czech Republic raised rates, and the markets are pricing in the start of a tightening cycle. Chile, Poland, and South Africa are likely candidates. South Korea has signaled it will likely raise interest rates before the end of the year. Taiwan and the Philippines are probably not far behind. Russia and Brazil are already a few steps into their policy adjustment, and additional moves are likely July and August, respectively. 

As the rotating head, Italy will host the G20 meeting on July 9-10 in Venice. There could be an opportunity for the US and China leaders to meet one-on-one. However, there cannot be a rapprochement with a significant change in behavior from China, in Xinjiang and Hong Kong, its trade harassment of Australia, aerial harassment of Taiwan, and its other provocative actions in the region. This is not particularly likely. President Biden has also made some vague threats if Beijing blocks an independent inquiry into the origins of the covid virus. The G20, which includes more emerging market countries, may push back against the minimum corporate tax proposed and the carbon tax, which is thought to fall disproportionately on them.

Biden appears to have grounded his “America is Back” campaign on forging a coalition to check China. Of course, Taiwan, Japan, and South Korea are keenly interested, though apparently not sufficient for Tokyo and Seoul to bury their historical grievances. Europe’s concerns are much more regionalized and seem to only be galvanized in extremis. It resisted US efforts to widen the mission of the North Atlantic Treaty Organization. Some opposition seemed to be based on political realism and commercial benefits, while others wanted nothing to dilute the efforts to contain Russia. Indeed, the fear of Russia in eastern and central Europe was sufficient to prevent a Merkel-Macron initiative to move the EU-Russian relationship beyond the post-Crimea stalemate.

China took three initiatives in June, and they all appeared to yield at least partial success. First, the reserve requirement on foreign currency deposits was lifted as part of the nuanced attempt to steady the yuan without resorting to overt intervention. The official efforts were aided by a general recovery in the dollar for most of June. Second, officials have spoken out against the rise in commodity prices. Many of the industrial metal prices seemed to respond more to the threat than the actual specific official plans to auction some metals from the state’s strategic reserves, some of which had been bought previously to support prices. The government is also cracking down on unlicensed producers. Third, China reiterated its ban on crypto financing, trading, and mining. This was one of the factors that appear to have sparked a significant drop in crypto prices. 

China is woefully behind in meeting the objectives of the two-year trade deal with the US. Although it was negotiated by the previous administration, it will be up to Biden’s team how the US will respond. Reports suggest China has largely rebuilt its swineherd, and this may also dampen some US exports (e.g., live hogs) while keeping grain shipments firm. Grain prices have become more sensitive to the drought in the western part of North America and in Brazil.

The CRB Index of commodities rose by 3.75% and finished June at its highest level in six years. Lumber prices fell by more than a third in June, leaving them about a quarter higher since the end of last year. On the other hand, early reports suggest that the wholesale market for used vehicles may have peaked, with retail prices expected to follow with a lag. The shortage of semiconductor chips also is reportedly become less acute.

The imbalance of the supply and demand for oil has sent crude prices soaring. US and China have been drawing down their reserves. The price of WTI has risen by more than 50% this year and has doubled since the vaccine was announced. Although OPEC+ is set to boost output, there is talk of $100 a barrel of oil again. We recall that the last few business downturns were proceeded by a sharp rise in oil prices. Although it is not yet the baseline view, the risks that the combination of the end of the fiscal stimulus, the exhaustion of the pent-up consumer demand, the excesses associated with the surging economy coupled with the dramatic rise in oil prices could spur a downturn late next year seem to be increasing. 

The Bannockburn World Currency Index, our GDP-weighted currency basket fell in June to snap a two-month advance. Most of the currencies fell against the dollar. There were three exceptions, the Brazilian real (~5.0%), Russian ruble (~0.4%), and the Mexican peso (~0.1%). However, together they account for 7% of the BWCI. The euro and Chinese yuan’s combined share is 40%, and they fell by around 3.0% and 1.4% respectively. The weightings will be adjusted next month based on the World Bank’s new 2020 GDP estimates.