Worst-Case Scenario for Markets: ‘Great Slowtation’

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As investors gear up for the Federal Reserve's monthly meeting, heavily anticipating further indications of when it might taper its monetary stimulus, strategists at Rabobank warn that markets could be subject to a "slowtation" if new data on the U.S. economy comes in as expected.

Uncertainty about when the Fed might start to rein in its monetary stimulus has caused significant volatility in financial markets in recent weeks. Investors have bet on higher yields by selling bonds, but if economic data were to come in weaker, those investors could face losses.

"We all know that the Fed is fundamentally biased towards easing (monetary stimulus). Despite what they might say in their Minutes and that they could increase or decrease from here, we know they're not going to increase from here. And so it's all about the speed at which they do that," Lyn Graham-Taylor, fixed income strategist at Rabobank told CNBC on Monday.

Instead, weak data will underpin speculation that the Fed will keep liquidity coming, which in turn will boost all asset classes, Rabobank said in an accompanying note.

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"While, at first blush, the notion of risky assets being supported by weak data seems rather paradoxical, this can be rationalized by the fact that fundamentals are of little importance in terms of indicators of activity but rather as gauges of liquidity – this given liquidity is arguably the key driver of asset valuations," Rabobank said.

Strong data should also allay concern the Fed might be too quick to taper, the bank said. This scenario supports the "great rotation" case which has come to prominence in the first half of this year and forecasts a shift from bonds into stocks.

But a slew of data close-to or modestly-above consensus could weigh on risk appetite – resulting in weaker equities and wider peripheral spreads; it could also weigh on U.S. Treasurys and German Bunds, Rabobank warned.

"This would be the worst possible scenario as regards the outlook for activity and, hence, is what we would term the 'Great Slowtation'."