Contagion threat for the U.S. lift-off

The market has thrown a September rate hike in doubt following the recent rout in Chinese equity markets which then spilled over to global markets.

The market only prices a 4bp increase of the effective fed funds rate in the Sep meeting (vs. a 17bp increase for a full hike). Whether the repricing of Fed expectations is justified hinges on how the Fed gauges the risks going forward of a significant slow-down in the Chinese economy and how negatively this would impact the US. The Fed's expectation of future equity and commodity market turmoil is also a factor as such volatility could disrupt US economic activity. 

"Our economists believe that channels of contagion from slow Chinese economic growth are limited and could potentially be offset by perceived "safe haven" capital inflows, and we continue to call for a hike in September", says BofA Merrill Lynch.

On the inflation front, TIPS breakevens have collapsed as oil declined and potential remains for USD strengthening versus EM currencies. This collapse is seen as a buying opportunity given that the Fed remains committed to raising inflation and inflation expectations as the July FOMC minutes suggested. If the Fed does hike next month, the front end of the curve, particularly the 5y point, will probably underperform the most, as the 5y sector appears most sensitive to the Fed cycle path. Whether the long end (10+ sector) increases in rate will depend on whether the market sees the hikes as too proactive or as appropriate given the data and the global environment.