Fed Minutes may temper Hawkish Dots

The second half is getting underway.  Five events should be on your radar screen, but do not lose sight of the broader context.  This year, the dollar has often experienced near-term trend changes around the turn of the month and the US jobs report.  

Consider the Dollar Index, albeit an imperfect metric.  The low for the year was recorded three days into January. It put in a high in early February and bottomed two days before the end of the month. The peak so far for the year was recorded on March 31, and then it trended lower in April before bouncing a little more than 1% into the end of the month and early May. Finally, it recorded a four-month low in late May and moved higher in June with two steps, before and after the FOMC meeting. 

A two-month high was recorded a couple of days after the seemingly hawkish surprise by the FOMC. The price action signs warn a new marginal high is possible, but the dollar's upside correction appears to be well advanced from a technical perspective.  We suspect a peak is near. 

The minutes from the recent FOMC meeting will be released on July 7.  The minutes may soften the sense of the hawkishness of Fed officials.  Apparently, what the market spends much of its time talking about, the individual members'  economic projections, the Fed spent the least amount of time.  In fact, one official revealed that there was no discussion about them at the FOMC meeting.  Ever since the "dot plot" was introduced in the aftermath of the Great Financial Crisis, Fed chairs have consistently played down their significance.  

Not to be confused by the facts, many market participants insist on putting undue emphasis on the Fed's dots.  Many seem to hear Fed-speak through the prism of the dots, so to speak.   It is putting the cart before the horse.  Apparently seeking to avoid a repeat of the taper tantrum in 2013, Chair Powell has repeatedly indicated that the Fed would give ample warning before tapering.  The consensus developed earlier this year remains intact: The Fed will announce its tapering plans at the late August Jackson Hold symposium or at the September FOMC meeting.  This has not changed.  

What changed was the market perceptions of the Fed's rate strategy.  A few days before the FOMC meeting, the December 2022 Eurodollar futures contract implied a 33 bp yield.  It rose to almost 55 bp before the end of June.  It finished last week near 50 bp.  With the cash rate below 15 bp, the market has about 35 bp increase in rates discounted.  That is a full 25 bp hike and 40% of a second move.  This seems particularly aggressive and something that the minutes are unlikely to validate.  If there is an adjustment in market views, it could help end the recent dollar recovery.  

Another central bank will demand attention.  The Reserve Bank of Australia meeting concludes early on July 6.   The key issue is whether the new lockdowns in the face of the Delta mutation that impacts an estimated 80% of the population will derail the RBA's effort to normalize policy.  The RBA is expected to not extend the 3-year yield target to the November 2024 bond in its version of yield curve control.  This seems to be low-hanging fruit and would likely come at little cost.  

The other decision is about its bond-buying, which runs through September.  It seems unlikely to come to a complete stop.  Instead, paring the buying back to A$50 bln seems reasonable with an eye to completing it by the end of the year.  RBA Governor Lowe, though, may complement the seemingly less accommodative stance with a push against the market that has priced in a rate hike in the first half of next year.  This might understate the aggressive tightening the market is discounting.  Consider that the three-month T-bill yields about three basis points.  The implied yield of the December 2022 T-bill futures reached 50 bp last week.  

The Australian dollar recorded a three-year high in late February, slightly above $0.8000. However, shortly after the FOMC meeting last month, it fell to new lows for the year near $0.7475. It retreated to $0.7445 at the end of last week before reversing higher.  The RBA cannot be unhappy with the recent price action.  After rallying by 30%, to rise it its best level since early 2018 on a trade-weighted basis, the Aussie has depreciated by slightly more than 4% over the past four months. 

The Bank of Canada does not meet until July 14. However, the employment report on July 9 is the third significant event in the week ahead.  Recall that at the April 21 meeting, the Bank of Canada had a palpable hawkish surprise.  In contrast to the Federal Reserve, it announced it would begin reducing its bond purchases (C$3 bln a week down from C$4 bln).  Unlike last year, when it reduced the purchases from C$5 bln but maintained the same level of stimulus by extending duration, it clearly signaled its intent to reduce accommodation.   

Governor Macklem also brought forward when it anticipates the economic slack will be absorbed to the second half of next year.  The market understood this to mean that a rate hike before the end of 2022 was likely. On the eve of that April meeting, the December 2022 BA futures implied a yield of about 95 bp.  It chopped around in May but rose sharply after the FOMC meeting.  It has been hovering in the 1.17%-1.23% range into the end of June and finished last week at the lower end of the range.  

Employment fell in Canada in April and May.  Full-time posts fell by almost 145k in the two months.  The Bank of Canada met shortly after the May employment report and did not seem particularly put-off by it.  The question is whether a third consecutive loss of jobs would give officials pause.  Canadian jobs data tend to be volatile even in the best of times.  However, it has not lost jobs for three straight months since 2014.  A better jobs report would likely resolve the debate for the market ahead of the Bank of Canada meeting on July 14. The typically macro drivers of the exchange rate: interest rate differentials (proxy: two-year swap rates), risk appetites (proxy:  S&P 500), and commodities (proxy:  oil) are still supportive of the Canadian dollar despite the pullback.  

The release of China's inflation early on July 9 in Beijing is the fourth macro event the commands market attention.  China's reported consumer inflation is tame.  Food prices are not the problem they were a year ago.  Last May, food prices had risen by 10.6% over the past 12-months and peaked in July with a 13.2% gain.  In May 2021, food prices had stabilized and were up 0.3% year-over-year.  Non-food prices were flat or negative year-over-year from July 2020 through February 2021.  In May, they stood 1.6% above year-ago levels.  

Headline consumer prices have fallen on a month-over-month basis for three months through May.  The decline has averaged a little more than 0.3% a month.  Price also fell in the three months through May 2020, and the average decline then was almost 1% a month. Last June, prices slipped by 0.1%.   A small increase in the June 2021 prices could have an outsized impact.  The year-over-year rate stood at 1.3% in May and is likely to have risen to around 1.5%.   Headline CPI is expected to rise by more than 2% next year.  

Producer prices have been more disquieting.  It rose by 9% in the year through May.  It seemed that even before China sells some industrial metals out of its strategic reserves and other efforts to arrest the price appreciation, producer prices have peaked. The output price component of the official June manufacturing PMI fell by 9.2 points to a one-year low.  

China's consumer prices have little impact on US CPI for numerous reasons, but consider that the role of shelter and medical services, education, and recreation are largely domestically driven prices and typically drive CPI.  Over the last five years, the correlation (of differences) is less than 0.15.  There is a tighter correlation between China's producer prices and US CPI.  

The correlation (of differences) between late 2008 and late 2013 was north of 0.60 for China's producer prices and American consumer prices.  It is not stable and fell below 0.20 by the end of 2014.  The correlation has tightened again and is now almost 0.55. Americans, like other consumers from high-income countries, spend more of their income on services than goods.  And even the manufactured goods that are commonly purchased are not raw material intensive, like computers and cellphones, clothing and footwear. A slowing in China's PPI may not spur a decline in expectations for US inflation.  That is a hypothesis that will be tested.  

Lastly,  the July 9-10 G20 meeting is important.  The G7 endorsed, and the OECD advocates the US proposal to impose a 15% minimum corporate tax and agreed in principle to ensure that the largest companies pay more taxes in the countries that account for their sales.  It is also pushing for a border adjustment tax that allows the importing country to tax goods with a large carbon footprint.  

Three considerations need to be understood before thinking about the outcome of the G20 meeting, even though a preliminary agreement was reportedly reached last week. First, it is not clear that a two-thirds majority in the US Senate will ratify the agreement.  Several Republican Senators have publicly objected.  Some Democrat Senators say they are concerned. If a global deal is not struck, the Biden administration will fear that its planned corporate tax hike will encourage other companies to book profits in the tax havens.  

Second, Ireland and Bermuda, countries with low tax rates, attract corporates from hedge funds and insurance companies to pharmaceutical and technology firms, are balking.   Others, including Hungary, Estonia, Nigeria, Kenya, and Peru, object.  

Third, the UK appears to have already secured a carve-out for its financial services.  The UK apparently persuasively argued that regulations require the banks to be capitalized in every jurisdiction, and they declare profits and pay taxes in the countries in which they operate.  It doesn't sound like the distribution of taxes more aligned with sales should be a problem for them, and they were included in the initial proposal.  The UK argued for the exemption because they would pay less taxes in the UK and more in other countries, which was the purpose in the first place.  Reports suggest that the UK made a concession to the US to revoke the digital services tax, which appears to single out American companies, and both the Trump and Biden administrations vigorously pushed against it. 

The exemption will likely reinforce the perception that the tax reform is highly political and is shaped by the druthers of large, rich countries. Moreover, the global environment is increasingly shaped by the tension between the US and China. The "America is Back" campaign is in large measure defined by "need" to check the rise of China. 

Beijing could reject the proposed 15% minimum corporate tax, but this G20 meeting may not be the right forum if it is going to do so.   The details have not been fully worked out.  It is the October summit that would be the proper venue. We suspect Beijing will see itself as negatively impacted.  Even though China has a 25% statutory rate, the largest companies are thought to pay considerably less.  The tax net that catches American companies like Google and Facebook will likely catch China's Tencent, Alibaba, and Pinduoduo.  It might suit the current administration in Washington's domestic agenda, but it does not mean that Beijing and New Delhi will abide.  

Concern about climate change and the desire to capture the "externalities" of carbon might appear above geopolitics. It has been identified as an area that the US and China might work together, but this is not occurring in a vacuum.  China consumes about half of the world's coal, and it is the biggest emitter of greenhouses gases partly for its own population, and partly for the goods it manufactures for the world.  In 2019, before the pandemic, China's exported about $2.5 trillion of goods (which was almost equivalent to 3% of the world's GDP).    

A carbon border adjustment would fall disproportionately on China.  It could favor one if it could blunt the impact by reimbursing them, for example, which like the UK carve-out for financial services, undermines the effort.  It is not like China is shrugging off its responsibilities or is in denial about climate change.  President Xi has endorsed the commitment to reach peak carbon by the end of the decade, representing a nearly 2/3 reduction and becoming carbon neutral by 2060.  It is expected to launch an emissions trading facility that may also provide additional incentives to reduce pollution.  

Even if one favors the minimum corporate tax and the better sharing of the tax revenue generated by the biggest companies and believes that using the tax code to encourage more friendly climate policies is a good idea, one needs to appreciate the geopolitical context.  The US is trying to forge a coalition to check China.  It makes no bones about it and pushes the democracies vs. authoritarian government framework.  Its global tax reform initiative comes after years of blocking such efforts which would also not benefit China.  The carbon border adjustment tax would also fall hard on it.  Coincidence?  

Beijing does not have to be an obstructionist.  Others may do the heavy lifting. It can wait to see if the US Senate approves the new tax initiative.  It would not be the first time a US President agreed to something, and Congress failed to affirm it.  Other countries are also likely to object to a carbon border adjustment tax, which looks and feels like a tariff.  While many observers reject the "new Cold War" framing, one of the implications is that the competition between the US and China is a powerful current that runs through and shapes many of the issues of the day, including international minimum corporate tax and a carbon border adjustment.  Few reports of the G20 meeting incorporate this into the analysis at their own peril.