FICS Editors' note

On Friday, July 6, the U.S. Labor Department released its June employment report, showing that hourly earnings rose at an annual pace of 2.7%.

Federal Reserve in the spotlight as summer markets feel the heat

It is unclear whether Jay Powell will alter course to ease bouts of global turmoil.

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Global markets are feeling the heat from the unilateralist policies of the Trump administration and that leaves investors looking to the US Federal Reserve for relief.

They may be waiting for a while and, in turn, that raises the prospect of a major market accident this summer, a time when market liquidity is generally thin.

The big question is whether the US central bank will continue tightening policy as the economic expansion for emerging markets, led by China, and the eurozone shows signs of having peaked.

Rising trade protectionism hardly improves the macro outlook — a point illustrated by further losses for global equities on Monday, while in the currency market, traders were once more favoring the US dollar across the board.

The strengthening US dollar has clearly intensified pressure on EMs, notably among its more indebted members. The BIS estimates that of the $11.4tn in dollar-denominated debt outside the US, one-third is owed by the non-financial sector, including companies, households and governments.

Hence, the increasing talk of a dollar shortage outside of the US among investors and policymakers that looks set to intensify.

The dollar is benefiting from upbeat US economic data, in sharp contrast with global rivals, a trend that keeps the Fed on a tightening track. Hefty redemptions from EM bond and equity funds show no sign of slowing and this also bolsters the reserve currency.

Later this week, a solid US employment report for June is forecast with economists expecting average hourly earnings will expand at an annual pace of 2.8 per cent, “matching the cyclical high recorded last September”, according to Brown Brothers Harriman.

That kind of macro backdrop will do little to alter the Fed from its present course or prevent further dollar strength. Hence, the increasing tone of market commentary about the parallels with 2015 and 2016, a period when the US central bank cautiously tightened policy and was clearly influenced by bouts of global market turmoil.

Emerging markets: What to watch

Not sure where prices are heading? Compare bond performances.

“The combination of Chinese equity market declines and currency depreciation pressures revive memories of 2015, and this combination has the potential to unsettle risky markets,’’ note analysts at JPMorgan. "Especially if a hawkish Fed or an escalation of trade tensions puts further upward pressure on the dollar.’’

Whether the Fed under Jay Powell adopts a more measured tone and recognizes the importance of the dollar in the financial system remains to be seen.

As Simon Derrick at Bank of New York Mellon notes: “If, in contrast to 2016, the FOMC [Federal Open Market Committee] remains indifferent to concerns about Chinese markets (as they have done so far) and the trade tensions increase from here then it is possible markets could experience a particularly turbulent summer.”

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