US manufacturing weakness could postpone Fed rate hike

The two channels of spill over from emerging markets to developed markets are, broadly speaking, the direct international trade channel and the financial channel. The latter includes developments in financial conditions, FX rates, credit spreads and equity markets. The former is related to weakness in exports due to both weaker demand in EM and loss of competiveness as EM FX rates plunge.

So far, most focus has been given to the financial channel but the latest data out of the US suggests that the trade channel is also starting to weigh on growth. This was highlighted by the advance trade data for August, which showed a 3.2% m/m decline in goods exports driven by a plunge in industrial supplies and autos. This is in line with the indications from the ISM manufacturing survey, where the new export orders index has declined to the lowest level since the peak of the euro area debt crisis in 2012.

The weakness in the US manufacturing sector increases the risk that the Fed will once again postpone the first rate hike and push lift-off into next year. Historically, the Fed has never raised the fed funds rate with an ISM below 50.8 and the September ISM dropped to 50.2. Details of the survey suggest that the ISM could decline even further in coming months as the new orders index declined further and the customer inventories index increased, suggesting that the inventory rundown will continue to weigh on the manufacturing sector in October.

"This raises a dilemma for the Fed as the labour market and private consumption on the other hand are posting solid growth rates. With the unemployment rate likely to undershoot 5% by the end of this year, the pressure on the Fed to start the tightening cycle is building. As long as wage inflation is not moving higher, FOMC Chair Janet Yellen will argue that labour market slack remains and postponing lift-off makes sense. If wage inflation does move higher over the coming months, it will be increasingly difficult for the Fed to push rate hikes into the future even with an ISM lingering around 50",says Danske Bank.