US Fed unlikely to hike next week

Next week, all eyes will be on the September FOMC meeting, at which the Fed will also release the updated summary of economic projections, followed by the press conference. The Fed is unlikely to hike next week, despite further improvement in the labor market, given the recent tightening in financial conditions and greater uncertainty about the inflation outlook. 

"The Fed is likely to pare back its 2016 forecasts for growth and inflation modestly, particularly given the strengthening of the broad trade-weighted USD since the June meeting. While it is also likely to lower the unemployment rate forecasts, NAIRU estimates should also decline, given subdued wage growth", says Barclays. 

Were the Fed to hike in this backdrop, it would be seen as a hawkish shift in the reaction function, resulting in a further tightening of financial conditions. Separately, the interest rate projections for 2015 and 2016 should drift lower. 

"Long Oct FF futures and short 3m5y straddle are recommended. Shorting the 5s10s30s Treasury fly is recommended, as very long-end forwards look attractive relative to medium-term ones. At the June meeting, the Fed forecast real GDP growth of 1.9% in 2015, rising to 2.55% in 2016, and y/y core PCE inflation to rise significantly to 1.75% by YE-16 from 1.35% at YE-15", states Barclays. 

With growth in the first half now looking better (at 2.15%), the Fed is likely to increase its 2015 forecast (consensus forecasts have risen 0.3pp since June). However, at the same time, the tightening in financial conditions since the June meeting should weigh on 2016 forecasts. 

The tightening has been broad based, SPX has fallen 7%, the broad trade-weighted USD has appreciated 5%, credit spreads have widened even outside the energy sector, and EM currencies have weakened. Even as 10y nominal yields have declined, 10y real yields have risen and 5y5y breakevens have tightened 35bp.