The US stocks tumbled last night, making most of its decline shortly after the opening bell. The Dow Jones Industrial Average (DJIA) plummeted more than 1,000 within the first four minutes of trading but a wave of buying reduced the Dow’s losses by half just five minutes later. For the trading session, the DJIA ended 3.6% lower while the S&P lost 3.9%. Macquarie Equities Research (MER) released a report yesterday stating that it shifts its base case for Fed liftoff to December. More excerpts are found below…..
 
 
MER shifts its base case for Fed liftoff to December. It’s updated probability assessment is Sept (30%, prev. 70%), Dec. (60%, prev. 25%), 2016 (10%, prev. 5%). The rate hike cycle should be cautious, gradual, and supportive of risktaking. While no longer MER’s base case, MER continues to see significant odds of a September hike, particularly one that could be accompanied by dovish accompanying language and projections. For example, FOMC members could lower projections for the long run Fed Funds rate (3.5%), which is currently well above MER’s forecast (2%). MER believes this will be reached only at end-17.
 
Cyclical peaks in equities have typically taken place ~ 6 months ahead of a US recession and MER’s work outlined in State of the Union suggests a low probability that one is on the horizon. Moreover, with headline inflation low, monetary policy remains flexible and any reduction in accommodation can be gradual. The decline in equities represents a buying opportunity.
 
The domestic situation alone supports a hike in September
The US domestic growth outlook remains strong in MER’s view. Uncertainty on this front was the rationale the FOMC used to push out liftoff expectations in March. Since then data have surprised on the upside, a development MER expects will continue in coming weeks. It is highly likely that FOMC participants will raise 2015 real GDP growth forecasts and lower end-15 unemployment rate forecasts in September. Doubts that existed about the resilience of the US economy in 1H are likely to have dissipated.
 
Underlying inflation measures have also remained firm, particularly given the circumstances of the oil price decline. Partially offsetting this is that aggregate wage growth has disappointed, but MER believes it should pick up in the months ahead as median individual wage growth is already accelerating.
 
But international and financial market factors now offset this
The FOMC has suggested the liftoff decision will also reflect i) inflation expectations, ii) international developments, and iii) financial market conditions. Developments here have shifted over the past week and, in MER’s assessment, now tilt the balance of probabilities towards December.
 
First, the Fed 5 year forward breakeven inflation rate has weakened and is barely off its lows from earlier this year. While much of this has been due to oil, MER nonetheless believe this gives reason to defer to December. Second, while global activity on the whole remains resilient, uncertainty on China’s outlook could provide the FOMC with reason to delay. This may persist in coming weeks. MER believes that while hard-landing fears are overdone, data in coming weeks may continue to disappoint. Third, the broad trade weighted USD index has accelerated.

Finally, weakness and volatility in financial markets have become a concern. While a ~10% decline in equity markets on its own may not be alarming to the FOMC, it is likely to want to avoid triggering further weakness out of fear that this would have negative feedback implications on growth and inflation. This would be a risk as market expectations for a September hike have fallen from over 50% earlier this month to 22%.

Source: Macquarie Research - 25 Aug 2015