Wall Street view on Fed rate hikes changing

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Wall Street appears to increasingly expect the Fed to send a more hawkish message when it meets next week.

Bank of America Merrill Lynch economists said they now anticipate the first Fed rate hikes in June 2015, instead of September, and they expect the central bank Wednesday to drop the language in its statement that says it expects to keep rates low for a "considerable time."

The Wall Street consensus for the first rate hike has been mostly around midyear and third quarter, 2015. But it appears to be shifting to the midyear mark.

In an analysis of recent Fed officials' comments, Goldman Sachs economists on Friday said: "We have seen a greater clustering of FOMC participants' views around mid-2015 in recent months, with a couple of more dovish members indicating a possible shift forward. Similarly, private sector forecasts for the first hike became more centered on mid-2015 from August to September."

JPMorgan's chief U.S. economist, Michael Feroli, on Friday said he also has joined the camp that thinks the Fed will tweak its language, after giving such a move 50-50 odds earlier in the week. He too pulled his view on the first rate hike forward to June.

"While it's a close call, we think the Fed drops the 'considerable time' language from the post-meeting statement. Fed speakers have recently highlighted increasing discomfort with this phrase, as it risks lulling the market into a sense of complacency regarding the Fed outlook," he wrote.

Feroli expects the Fed could try to avoid rattling the market, which would expect rate hikes sooner, with language that would reassure markets about its low-rate policy.

Wall Street has been divided on the how and when the Fed moves toward normalcy. But speculation has been running rampant, especially as its policy path is diverging while the European Central Bank embarks on its own easier policy and the Bank of Japan continues to add stimulus. Bond yields have been rising as a result.

"Of course, pinpointing the exact timing of the first rate hike is more of a guess than a forecast. Nonetheless, the case for an earlier move has grown over the last several months. The growth data have been a bit stronger than expected," wrote BofAML global economist Ethan Harris. "Inflation has been in line with the Fed's forecast, but a bit stronger than our own. Asset markets continue to be supportive of growth, with lower-than-expected bond yields, solid gains in asset prices and continued re-engagement of the banking system. Finally, there has been a gradual change in rhetoric from Janet Yellen and her allies."

Harris said he expects the Fed to then hike rates at every other meeting for the first year and a half of the tightening cycle. "We continue to believe doom and gloom stories like 'secular stagnation' are overdone. We also expect the Fed to eventually overshoot its inflation target, suggesting a peak funds rate of over 4 percent and eventually they could return to a normal rate of 4 percent," he noted.

Rates were rising early Friday morning but an expected 0.6 percent improvement in retail sales in August and an upward revision to July's flat report gave bond yields an extra kick. Several economists said consumption could be stronger than expected, likely giving some lift to third-quarter GDP.

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"It's all part of the same thing we've been seeing in September. Any data point deemed to be positive will further the argument that a change in the policy statement and the Fed's tone is likely to change next week," said Adrian Miller, director of fixed income strategy at GMP Securities.

But Miller is still part of a seeming minority who are convinced the Fed on Wednesday will drop the "considerable time" language. A CRT Capital survey of bond market participants this week showed that 68 percent put the odds of a language change in the Fed statement at less than 50 percent.

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The 10-year yield, at 2.50 percent on Thursday, rose to 2.60 on Friday, the highest since July 31 and well above its mid-August low of 2.34 percent. Yields have also been rising in tandem with European sovereigns, which are reflecting unease about the Scottish independence vote and some uncertainty about the ECB's promised asset purchase program.

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David Ader, chief currency strategist at CRT Capital, said the Fed is the main theme in the bond market move but other factors are affecting it, including technicals and repositioning after currency moves.

The market is also bracing for the end of the Fed's quantitative easing bond-buying program in November. The central bank has said it would announce its final tapering of the program at its October meeting.

"We all want to get excited and hyped over the Fed, but maybe this meeting isn't the one to get excited about. While there will be a lot of talk about forward guidance and the position of the dots (which reflect Fed officials' rates forecasts), that stuff has been so wrong," said Ader. He said there clearly is profit-taking ahead of the Fed.

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Speculation about the Fed's statement was ignited by comments from several central bank officials last week. The hawks have been calling for earlier rate hikes than the market expects. But a couple of Fed officials recently said the bank should focus on data and not calendar-based guidance. One of those was dovish Boston Fed President Eric Rosengren, though he did not change his view on keeping rates low.

Those comments were followed by a San Francisco Fed staff paper Monday that said investors are behind the central bank in terms of rate expectations.

The market players that expect a language change also point to the fact that Fed Chair Janet Yellen has a press briefing following the Wednesday afternoon statement and forecast release, and she could use that as an opportunity to reinforce the Fed's dovish message in the event the market takes a language change as a sign the central bank could move to raise rates sooner.

"We think Yellen and her allies will try to avoid shocking the markets. In the past, when the FOMC has reworked its forward guidance, they have often softened the blow by explicitly noting that their view on the likely timing of the exit has not changed or by downplaying the change in the press conference," Harris wrote.

He also noted that the Fed would probably continue to emphasis the "significant underutilization of labor resources" in its statement because of the weak August jobs report, which added just 142,000 nonfarm payrolls. It could also try to neutralize the removal of the "consideralble time" language by saying there has been a "considerable" reduction in labor slack and "notable" progress toward its inflation goal.

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Miller said the Fed will be giving itself more flexibility if it removes the "considerable time" language. "I think it's an interpretation issue. ... By removing the time elements, the market will interpret a path to rates rising sooner. I still think it's a June date irrespective of them changing the language," he said.

Miller also said the move in yields makes sense. "A 10-year at 2.40, where it was a little while ago, was unrealistic. At 2.60 it's more in line with fundamentals," he said. Miller noted that yields were higher earlier in the summer, and the stock market did not bristle then, but moved higher. "The difference is now you have this overhang of the Fed."

While the yield curve trend has been flattening, the curve steepened Friday as longer-duration bonds moved higher, away from shorter-duration securities.

"The trend has been flattening. Part of the rhetoric was about opening up potential for a sooner hike. That caused the front end to outperform, and you saw this flattening effect," Miller said. "Steepening is an indication people are buying into the growth elements as opposed to the policy expectations elements."

Ader said the bond market was also keeping an eye on the surge in corporate bond issuance.

"The other thinking that is creeping into the fray is the behavior of credit and the stronger dollar is a negative for corporations. It hurts them competitively overseas on exports and makes imports more exciting. It reduces profitability in terms of overseas operations. You're hearing some concerns ... maybe now we're supposed to see some underperformance," he said. At the same time, issuers are rushing to market to get in ahead of higher yields.

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—By CNBC's Patti Domm