Fed moves closer to policy change in week ahead

With stocks range bound, traders await the Fed's latest message on normalizing policy, after nine years of no interest rate hikes.

The Fed holds its June meeting on Tuesday and Wednesday and is not expected to take action when it releases its statement Wednesday afternoon.

But traders anticipate that Fed Chair Janet Yellen will have a message for markets when she holds a briefing after the meeting, and they will be looking for clues on whether the Fed would be ready to embark on its first rate hike in September, as many expect.


Besides the Fed, there are a few important economic reports including industrial production Monday and the consumer price index on Thursday.

"As long as you don't see an accident in Europe with Greece, the Fed will raise rates when they feel it's appropriate. The stock market can handle this," said Paul Richards, UBS managing director, head of FX distribution, Americas. "The stock market, to me, doesn't have the Fed to worry about. The stock market's next test is Q2 earnings."

Richard said the dollar could trade firmer into the Fed meeting.

As for the Fed, Richards said he expects Yellen to reiterate her recent comments that the Fed could raise rates this year if the economy is strong enough. Recently, economic data has contained more positive surprises than negative, and the second quarter is now tracking closer to 3 percent growth than 2 percent.

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"I expect an element of optimism. The tone coming from the Fed looks positive," said Richards. "At the end of the day, you're really wanting to listen to Yellen, (Fed Vice Chairman Stanley) Fischer, (New York Fed President William) Dudley. All of them are telling you, they want to raise rates this year. She's going to have to mention the recent positive data and will give herself the optionality that the data has to keep going up."

Stocks were barely changed on the week, despite volatile trading days, and Treasury yields, also volatile, ended close to the week earlier level. The 10-year Treasury, following the bund yield, hit a high of 2.50 percent Thursday before slipping back to 2.38 percent. The S&P 500 ended the week flat at 2,094, a less than 0.1 percent change from the week earlier.

According to Bespoke, the S&P is on its longest streak of less than 1 percent weekly moves since 1993. This past week was the seventh, and while some strategists have been waiting for a pullback, others say the market could continue to churn in a range until the economic data proves to be consistent, and the Fed's path to rate hikes, are clearer.

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"I think the Fed may give us a signal they want to tighten. The bond market is certainly leaning that way, and I think the bond market is rolling out a red carpet for them," said Jack Ablin, CIO of BMO Private Bank. "We have these two binary events— the Fed and Greece—capturing peoples' attention and creating incremental volatility but neither should cause a big stir."

Negotiations between Greece and its creditors have been tense, but Richards expects a resolution to come in the final hour, and also does not foresee a problem for markets.

As for stocks, Ablin said he expects the market to react to the Fed more in the months after it begins raising rates because unlike other cycles, the Fed will move more slowly and not hike at every meeting. "I think what they'll do is embark on the tightening cycle and keep everybody guessing. The risk base of equities will likely rise, so it will put more downward pressure on equities as rates rise."

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He does not expect stocks to be on edge around the Fed's message in the coming week. "We're still in the September camp, and I don't think there's anything they will do to change that," he said.

Jim Caron, global portfolio manager at Morgan Stanley Investment Management, said he expects the Fed to downgrade its view on the economy, given the first-quarter contraction, and lower its outlook on inflation. The Fed forecast growth of 2.3 to 2.7 percent this year. The markets are also watching to see how Fed officials change their views on the path of interest rates.

"I think the (bond) market is going to be reluctant to be too underweight or short. If we're sitting at 2.25 (10-year yield), I think people will be short. If we're at 2.50 going in (to the Fed), people will want to get long," he said.

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Ablin said the Fed's message, if it does reiterate a willingness to raise rates, will be a positive for the financial sector, which gained nearly a percent this past week and 1.7 percent in the past month.

Ablin said the market performs better when the financials are leading, and so far they are not. But the recent rally was clearly in anticipation of a higher rate environment, which would help bank earnings.

"It seems the coast is clear for financials, at least relative to the rest of the market," he said. Ablin said the S&P's return against the financial sector's return relative to the broad market, shows a 73 percent correlation. He said the trend was consistent when he tracked it back 22 years.

Therefore, if financials continue to rise and outpace market gains, that could be positive for the broader market if borrowing costs rise in an orderly manner, he noted.

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What to Watch

Monday

8:30 a.m.: Empire State survey

9:15 a.m.: Industrial production

10 a.m.: NAHB survey

4 p.m.: TIC data

Tuesday

FOMC begins two-day meeting

8:30 a.m.: Housing starts

Wednesday

2 p.m.: FOMC statement

2:30 p.m.: Fed Chair Janet Yellen press briefing

Thursday

8:30 a.m.: Initial claims

8:30 a.m.: CPI

8:30 a.m.: Current account Q1

10 a.m.: Philadelphia Fed survey

Friday

11:40 a.m.: San Francisco Fed President John Williams on policy

12:45 p.m.: Cleveland Fed President Loretta Mester on community development and the Fed