• Market volatility picked up this week after a post-Brexit summer slumber, with moves dominated by speculation on whether we’ve seen the bottom for longer-term global interest rates. Hawkish statements by Fed presidents were trumped later by governor Lael Brainard’s speech, convincing the market that the fed will wait until December for its next rate hike.
  • Mixed U.S. economic data this week was consistent with a cautious, patient Fed. Weaker than expected retail sales and industrial production data for August suggested modestly slower growth in 16H2, while stronger inflation data is consistent with absorption of economic slack.
  • Global economic data show growth picking up in the second half of the year, but financial fragilities remain at the forefront. Speculation about BoJ policy added to the pressure this week, spurring a sell-off in advanced economy bonds. A repeat of the 2013 taper tantrum episode would have serious negative repercussions on the U.S. outlook.


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In the lead-up to next week’s FOMC meeting, market action this week was dominated not only by speculation of whether the Fed would raise rates, but also concerns that maybe, just maybe,Financial News- Chart 1 longer-term global interest rates have finally troughed. Markets gyrated the most we’ve seen since Brexit this week, driven by rumours of a forthcoming reverse Operation Twist by the Bank of Japan next Tuesday and somewhat contradictory Fed-speak, as hawkish speeches by Presidents Rosengren (Boston) and Lockhart (Atlanta) were countered by a dovish speech by Fed Governor Brainard . The mixed U.S. data flow this week is consistent with a patient Fed. Following strong performance this spring and summer, retail sales growth slowed over the last couple of months, implying a slowdown in spending by U.S. households in the third quarter of this year. And, in alignment with the weak ISM manufacturing print earlier this month, industrial production contracted a little more than expected in August, driven by greater payback in utilities from July strength. On a somewhat more positive note, the pick-up in headline and core CPI this morning suggests that excess capacity continues to be absorbed. One of the largest contributors to core CPI this year has been core services, driven largely by ongoing improvements in the housing market (Chart 1).

The global data flow this week was generally positive, confirming that demand is heating up in the second half of this year. UK retail sales for August failed to fully reverse the strength in July, giving further credence to the idea that the UK economy post-Brexit is generally evolving in line with the Bank of England’s August forecast. Furthermore, Chinese data for August confirm that growth will remain close to 7.0% (annualized q/q) in the third quarter, driven by strength in the services sector.

However, underneath this thin veneer of global stability Financial News- Chart 2 are risks to financial stability that, if realized, could easily spillover and derail the Fed’s normalization of monetary policy. These concerns resurfaced once again this this week as the Bank of Japan (BoJ) became the focus of speculation on whether it would act to ease next Tuesday. Rumours of a reverse Twist – whereby the BoJ would purchase government bonds on the short-end of the yield curve (assets with <10 years maturity) and reduce or eliminate purchases of assets with longer maturities – helped spur a bond market sell-off in advanced economies. While the benefits of this policy shift would likely be limited, the potential risks of generating another term premium shock similar to that of the taper tantrum episode in 2013 cannot be understated.

As we show in Chart 2, a shock to U.S. term premiums similar in magnitude to that observed in 2013 would be detrimental to the outlook for the U.S. economy. Business and residential investment would be hardest hit, falling close to 3% and 2.5% respectively below our baseline by the end of 2018. Overall, U.S. economic output would be about 1.2% weaker.

All told, with signs that excess slack continues to be absorbed in the U.S. economy and global demand is recovering, conditions are ripe for a fed rate hike. However, the risks remain titled to the downside, implying that a cautious Fed will likely defer a rate hike until December.

Fotios Raptis,  Senior Economist

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