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Yellen says a rate hike is coming—but markets say not now

Fed Chair Janet Yellen signaled a rate hike could be coming this year, but December is still seen as more likely even though Yellen opened the door wider for September and markets increased the odds of an earlier rate hike.

The markets initially read Yellen's much-anticipated Jackson Hole, Wyoming, speech as slightly hawkish, but then saw it as benign with no impact on expectations the Fed would move sooner than December. Stocks rallied, bond yields drifted lower and the dollar fell.

But many of those moves were reversed after Fed Vice Chair Stanley Fischer put the focus on next week's August jobs report and forward data, in an interview with CNBC. Stocks turned lower and the dollar turned positive as Fischer spoke just before midday. Fischer noted that the economic data has strengthened with strong jobs growth in the last three months.

"In our view, if the employment report continues to indicate an improving labor market, the FOMC may well raise rates at the September meeting," wrote Goldman Sachs economists. "As a result, we have increased our subjective odds of a hike at next month's meeting to 40 percent from 30 percent previously."

In the interview, Fischer said that Yellen's comments were consistent with a September rate hike and possibly two hikes this year, but the Fed won't know the course of normalization until it sees the data. He said that inflation is increasing though it remains below the Fed's 2 percent target. "We're reasonably close to what is thought of as full employment," Fischer said. On Monday, the Fed's preferred inflation measure, the PCE deflator will be released and on Friday, August nonfarm payrolls are reported.

"Fischer didn't say anything different than he said earlier. (Yellen) had put everyone on notice for a rate hike in September," said Peter Boockvar, chief market analyst at The Lindsey Group.

But Boockvar said Fischer's emphasis on the upcoming data made market participants rethink the potential for an earlier rate hike. Fed funds futures showed market odds swinging higher to 34 percent for September, from less than 30 percent, and to 60 percent for December, from less than 55 percent.

"All she said was the case for a rate hike has strengthened in recent months," said Ward McCarthy, chief financial economist at Jefferies. "The lack of specificity on a timetable looks like it's going to happen later rather than sooner."

Yellen appeared just before her 10 a.m. EDT speech, flanked by Fischer and New York Fed President William Dudley. The three are viewed as the core of the U.S. central bank, and the most influential in setting policy.

Fischer and Dudley had somewhat raised market expectations that Yellen's commentary could be a tinge more hawkish. Dudley had said last week a rate hike was possible soon, maybe even in September, and Fischer had said over the weekend that the Fed was close to meeting its objectives.

But the Fed is also data dependent, and next Friday's August jobs report is now at the heart of speculation about a September hike since Yellen has now left the door open. Fischer, later appearing on CNBC, said the Fed would be forward looking, and the next jobs report will figure into the process.

After Fischer spoke, the 2-year note yield rose to 0.83 percent at midday, a level it has not been at all summer. The 2-year is the most Fed sensitive part of the curve.

"I think it would be foolish to ignore that a strong jobs number next Friday is something that could actually make the Fed move. I think the market will take it seriously if we have a strong number," said Gene Tannuzzo, senior fixed-income portfolio manager at Columbia Threadneedle Investments. "If we have a lousy number, sure, you would take the Fed off the table."

John Briggs, head of strategy at RBS, said the market had expected her to be somewhat hawkish but it took comments from Fischer reinforcing that the economy is improving and the Fed's objectives are getting closer to emphasize that September is in play.

"While she's more confident, I don't get the sense of immediacy, even though September is not ruled out. So, as long as there's no downside shocks, the economy is moving in the direction where a rate hike is more appropriate," said Briggs. "Personally even in that case I see December as more likely."

The Fed has said it could raise rates twice this year, but the market has been focused on one hike at most and more likely December, than any other month, given the inconsistency of data and the U.S. presidential election. The fact Yellen did not go into detail on the possibility of more than one increase made a hike seem less immediate than Fischer's comments.

"If the market continues to see a September hike, the 2-year yield could near 1 percent," Briggs said.