Markets highly data-dependent as they await the Fed lift-off

Fed lift-off is looming. This week's US employment report added further evidence that the labor market recovery remains solid, with a 215,000 increase in nonfarm payrolls and a steady 5.3% jobless rate. Our US team thinks the Fed will hike in September unless the data turn bad or there is a major global shock. Hence each healthy report raises the probability of a September move. 

The beginning of interest rates normalization in the US need not be a disruptive market event, but it does change the house rules. As the data-dependent Fed gets going, the risks of US rates shocks increase. In particular, while a 2H 2015 lift-off has been on the cards for some time, markets are still adjusting to the news of greater EM frailty. Lower commodity prices, political instability and ebbing growth expectations in the region suggest the global rapport with Fed hikes will be rockier. 

How EM copes with the Fed hiking cycle depends on a few factors, according to BofA Merrill Lynch research.

• It starts with the effectiveness of Fed communication, diminishing the risk of a policy surprise. The next layer of complexity comes from market and global economic fundamentals, which can amplify the Fed signal. The EM policy response also matters greatly, as the botched initial response to the tapering tantrum in Brazil and India showed. A final factor is the risk of "spillbacks" from Fed-induced EM turmoil back to the US.
• The FOMC has carefully shifted from calendar-based to data-dependent guidance. However, for this to work in practice, the Fed needs the market to be on board, moving significantly in response to data surprises. One simple gauge of Fed credibility, therefore, is the extent to which markets are being swayed by data releases.
• The shift into data-dependence introduces more volatility, but that is not necessarily bad news for EM. If expectations of Fed rate hikes are driven by the data rather than Fed commentary there is a more positive message for US trading partners--yes the Fed could hike, but US import demand could be higher as well. The IMF notes in its latest Spillover Report that real and policy shocks (in either the US or the euro area) have "vastly different" spillover effects on other economies. Real shocks will likely lead to higher capital inflows and an increase in industrial production, while policy shocks do the opposite.
• Effective Fed communication is necessary, but not sufficient to prevent market wobbles in EM. It also depends on what is happening on the ground. Factors such as growth differentials with the G4 economies, inflation, the fiscal position, current account balances and the extent of non-resident participation in local bond markets repeatedly pop up in empirical exercises linking capital flows to domestic fundamentals. These fundamentals matter less, however, during times of heightened risk aversion. 
• While Asian economies top the fundamental rankings, there are also localized concerns. As EM Asia economist Hak Bin Chua noted last week, Indonesia and Malaysia are the economies most likely to suffer capital outflows if the Fed surprises on the hawkish end. Indonesia has a current account deficit, elevated inflation and moderating growth, while Malaysia remains vulnerable due to its high external debt, low FX reserves cover to short-term debt and elevated household debt.
• Earlier this year markets were surprised by the extent of EM monetary easing on the heels of the oil price plunge. It seemed bold to keep lowering interest rates in face of not only significant FX depreciation, but also the approaching Fed lift-off. We noted, however, that significant easing was justified. The degree of FX pass-through appeared to have moderated. Moreover, many EM central banks have gained enough credibility to focus more on the domestic economy. 
• Some central banks have less policy space, however. Looking at estimated Taylor Rules, we found that policymakers have been less reactive to the domestic output gap in Turkey, Brazil, Russia and Indonesia. While we indeed expect central banks in Turkey, Brazil and Indonesia to stay on hold for now, falling inflation should allow the Russian central bank to ease. Through to the rest of 2015, our GEMs team expects policymakers to cut rates in Russia, Colombia, China, India, Malaysia and Thailand. 
• Emerging markets have been battered by falling commodity prices, diminishing growth expectations and capital outflows. While this suggests a more vulnerable position ahead of Fed lift-off, the region is undergoing a significant adjustment. Compared to the tapering tantrum, EM FX is now much weaker and market volatility has been notably higher to begin with. Looking ahead, much depends on Fed communication but we think a number of EM central banks will be able to watch the Fed from a safe distance.