US Fed may defer Sept rate hike, dollar still robust owing to Chinese disruption

The global equity cues have thrown a September rate hike in dubious following the recent rout in Chinese equity markets which then spilled over to global markets. The market only prices a 4 bps increase of the effective fed funds rate in the Sep meeting (vs. a 17 bps 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.

We believe that the 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. On the inflation front, TIPS breakevens have collapsed as oil declined and potential remains for USD strengthening versus EM currencies.

We see this collapse as a buying opportunity given that we think 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.

Currency forecasts: Core USD long remains intact, we continue to expect policy divergence and US growth outperformance to underpin the dollar, even if downside risks in China are realized. We did push up our forecast profile for EUR-CHF and lowered it for both AUD-USD and NZD-USD. In EM currencies, however, there are a wide variety of changes on the back of the CNY depreciation. The forecast for end-2016 CNY is now 6..90, along with a wide number of subsequent changes in EM Asia. We also pushed up forecasts for major EM profiles such as USD-INR, USD-MXN and USD-BRL.