Fed's rate hike and its implications

With a final solid payroll number under the belt, focus now turns squarely to the Fed'sSeptember 17th rate hike decision. BofAML describes the economic and policy backdrop and then looks at likely market responses to alternative Fed scenarios:

• The fundamental backdrop for growth has improved with healing from the financial crisis and relative calm on the fiscal front.
• After a wobbly start to the New Year, the data now point to steady 3% or so GDP growth and an even stronger recovery in the labor market.
• Inflation will likely remain weaker than both Fed and consensus forecasts, however, the Fed seem willing to blame the weakness on temporary factors and focus on upside pressure from a tightening labor market.
• There has been a regime shift at the Fed. Until 2013 the Fed was resolutely focused in healing the economy and avoiding a "Japan Scenario." With healing well advanced, however, now they have shifted to "data dependent" mode. The Fed's "bias" is to act, all it needs is confirmation in the data.
• Three scenarios seem plausible for the Fed: our base case is that markets stabilize and the Fed hikes this month, the second most likely scenario is that the Fed remains uncomfortable with market fragility and delays hiking until October or December; and the least likely scenario is that shocks to the economy worsen, damaging growth and turning a temporary delay into a semi-permanent delay.
• What happens after the hike? We continue to expect rate hikes at every other meeting, or at less than half the usual pace. Moreover, the risk is that that they start out even slower, hiking every third meeting. We will revisit this question as the Fed focus shifts and they drop more hints about the pace of hiking.

What does all this imply for capital markets?

• As this goes to press, a September move is only partially priced in. However, the first hike will likely be seen by many as a "policy mistake" limiting pressure on the rates market. The bigger shock will come if the Fed follows through with a sequence of hikes.
• Rate hikes will not come as a big surprise to the currency market, but our work suggests that the sharp move higher in the dollar in the last year was mainly due to growth concerns and easings by other central banks. With Fed hikes not fully priced in, we expect modest further upward pressure on the dollar versus a wide range of currencies in the period ahead.
• Some volatility in Emerging Markets (EM) is likely, but the current situation differs significantly from the 2013 "taper tantrum." Taper talk was a surprise; a rate hike now is not. Moreover, EM currencies are a lot cheaper and are undervalued according to Compass FX, our valuation model. Also, there are only small external imbalances in the Fragile Five. Finally, positioning is less extreme and institutional investors dominate the market. These have proved to be more resilient than the retail investors in 2013. 
• In the near term credit should react favorably to liftoff as it is supported by US data and market stability. However, further into the rate hiking cycle credit markets will struggle as they were big beneficiaries of the Fed's super easy policy in recent years. This as retail and institutional investors "unreach from yield" and switch back to safer fixed income assets and equities. 
• For stocks, growth matters most, and the backdrop of a gradual tightening cycle should be supportive of stocks, outperforming bonds and cash, as long as growth improves. In our view, we have yet to see the highs in stock prices for this cycle, but a delay in the Fed liftoff would prolong the uncertainty, overhang on the market, thereby extending volatility. 
• Higher US rates will impact commodities in a number of ways. As a first order effect, higher US rates will likely drive up the US dollar further, likely impacting commodity prices negatively in the short-run. A key second order effect, however, will be reduced funding capacity across the commodity sector, a factor that should ultimately lend support to commodity prices in 2016. 
• Putting it all together, the Fed exit is good for the dollar and volatility, roughly neutral for stocks and bearish for commodities and bonds, particularly for credit. Overall, we see positive, but lower returns for a diversified investor.