The Fed will likely buy time - Scotiabank

Derek Holt, Research Analyst at Scotiabank, suggests that the markets will hang on any potential signals to an economy growing around 2.5% good enough for the Federal Reserve to contemplate the second rate hike of this cycle as Q2 GDP growth and another Fed meeting dominate market attention.

Key Quotes

“Second quarter GDP accounts officially arrive after the FOMC statement. Like private forecasters, however, the Fed likely has a reasonable degree of comfort in the narrative surrounding a decent if unspectacular rebound in Q2 following the usual Q1 disappointment. Each of Bloomberg's consensus, the Atlanta Fed's 'nowcast' and our own estimate point to growth in the mid-two-handled zone.

The factors governing the FOMC outlook are, however, far more complex than just tracking the domestic economy. A statement-only effort by the Fed on July 27th will defer fresh forecasts and a press conference until September following the Fed's August vacation. Inflation remains beneath target as Governor Tarullo notes while questioning any need to rush policy tightening. The Brexit outcome connotes complex after-effects, as NY Fed President William Dudley has observed. It would seem to us that these two factors merit taking time to avoid an overly hasty interpretation of the ability of the global economy and markets to withstand US monetary policy tightening.

Among the complex considerations are rising duration and changed dynamics in global bond markets that connote greater potential for destabilizing market effects in the wake of a Fed hike. Further forecast easing of monetary policy at the BoJ, ECB, BoE and numerous other central banks such as the RBA and RBI pose the risk of another downward adjustment to foreign bond yields. This would alter the carry trade into dollar bloc assets and with it lift demand for Treasuries and the USD.

Indeed, the broad dollar index has been rising for some time already. USD strength could therefore do the Fed's policy tightening, independent of Fed hikes and driven by external developments. USD strength, in turn, could spark another round of disinflationary currency pass-through effects into US inflation readings while further dampening US export competitiveness. Should the Fed fan such effects through hints at rate hikes, then it risks overheating the dollar in destructive fashion.”