The FED, Emerging Markets Rally and Brexit


Last week, the US equity market posted its best gains since July and it seems that further gains could be in store. Now cast models suggest the US economy has expanded by about 3% in Q3, but our US economics team suggests that Q4 growth is set to slow from here. The degree of the slowdown may decide whether the Fed may increase rates in December or not. Our verdict remains for no hike suggesting markets repricing the current 54% probability of the Fed moving by December. At this stage weaker US data suggests lower rates for longer. Anyhow, even hawkish members of the FOMC such as the dove turned-hawk Rosengren put the need for higher interest rates into the context of ‘market imbalances’ instead of economic needs, underlining that the Fed’s current rate hike cycle may be an unusually flat profile, arguing too for USD weakness.

There had been a number of hints suggesting the economy slowing from here, most notably the recent decline of consumer confidence, weak August retail sales and weaker credit demand. Last Friday, tax collection data showed a steep decline too. Hence, it seems that our call for a weaker US economy / weaker USD is well embedded within the current US economic findings. The biggest risk to our call for seeing the Fed’s broad USD index falling 4% from here comes from US politics where the debate between the two Presidential Candidates Clinton and Trump will be in focus this evening. The MXN’s high weighting (11.7%) within the Fed’s USD index plus the impact on risk appetite could lead to a higher USD should markets view the outcome of the debate unfavorably.
Otherwise, EM’s high yield rally should remain on track. The strength of the liquidity induced rally may be tested today as the market deals with Moody’s announcement right around Friday’s NY close of its downgrade to Turkey’s foreign currency ratings to Ba1/Stable, taking the country to sub-IG with two of the three major agencies. We estimate that there could likely be some forced outflow related to a downgrade to the tune of about US$3 billion in sovereign credit and US$2 billion in local bonds. Should the market be able to absorb this supply then market confidence into the EM high yield rally may rise again.

The better risk outcome should stabilize GBP in the short-term but with Brexit-related uncertainties remaining high, sterling gains may be limited. “Hard-Brexit” talk is making headlines again with implications particularly for the financial industry. The FT quotes industry representatives suggesting no-clarity on this issue could trigger the industry’s exit plans. Tomorrow’s September CBI retail sales report, followed by Wednesday’s August consumer credit and Thursday’s September Nationwide house price index, may provide markets with another GBP selling opportunity should these data come in strong. Thursday’s Q2current account data may underline once again that a demand side economic rebound increases external funding risks should the supply side of the British economy weaken from here. This may happen should Brexit talks not focus on the UK maintaining full EMU market excess. Slower business investment tends to hit an economy with a delay given the multiple months’ lag between business investment and execution.