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Look Ahead: Fed's Move Will be Talk of Friday's Markets

The Fed surprised markets just after the New York close Thursday by hiking the rate banks pay for emergency loans by a a quarter point to 0.75 percent, a first step on the road to unwinding the programs it used to fight the financial crisis.

The action itself was not a surprise, since the Fed has been warning a discount rate hike would be its next move. However, the timing was sooner than many investors expected and the after hours move gave the markets a shudder.

Economists say it will also have no direct bearing on consumer rates and does not mean the Fed will speed up its hiking of the Federal funds rate, which more directly impacts consumers and mortgages. At the same time, however, rates in the Treasury market have been rising and if that continues, it could have a bearing on mortgages and consumer and commercial credit costs.

The Fed's move immediately sent stock futures lower, pushed the dollar higher and unleashed selling in 2-year Treasurys. Traders expect more fall out in stocks and bonds Friday, and the dollar could stay firm. Friday is also the double expiration of options on equities and indexes, an event that had been seen as a positive for stocks.

"The way I would look at it is the Fed believes that the markets have effectively healed," said Deutsche Bank chief U.S. economist Joseph LaVorgna. "If you look at the Fed's balance sheet, a lot of these programs aren't in effective use any more. Therefore the Fed wants to symbolically show things are better. Spreads have come in. The markets are acting more normally again."

Barry Knapp, head of U.S. equity portfolio strategy at Barclays Capital, said the Fed's move was expected, and stock futures overreacted initially.

Markets have been grappling with the Fed's intentions on when it will withdraw its easy money stance since Fed Chairman Ben Bernanke released a text of his thoughts on the Fed's exit strategy last week. For that reason, the minutes of its last meeting, released Wednesday, created even more of a stir in the bond market when they showed disagreement among Fed members on when the Fed would start making moves to reduce its balance sheet.

LaVorgna said this is a step toward normalcy, and the Fed does not see itself as the necessary back stop it had been for markets and financial institutions. "Part of that is to narrow the spreads of the discount rate to the Fed funds rate because if a bank comes to the (Fed) window now that things are better, it should pay a penalty rate,." said LaVorgna. Historically, he said the spread between the discount rate and Fed funds rate has been a point. They are now a half point apart, with the Fed funds at 0.25 percent.

Interestingly, the Fed made its move on a day when the Treasury yield curve (between the 10-year and 2-year yields) spread to historic wide levels. The steep curve was seen by traders as a warning sign about Treasury supply issues and potential inflation. It also occurred on the day the producer price index showed a larger than expected jump in inflation at the wholesale level, up 1.4 percent in January.

"That (yield curve) says the Fed policy is pretty accommodative and they're going to need to change that. You don't want that thing getting too steep because inflation expectations will start to rise," said Knapp.

CNBC's Rick Santelli reported that the Treasury yield curve was "well ahead of the Fed in the tightening direction."

"The 2.90 plus historic basis points spread between 10s and 2s is evidence of that. Traders view the discount rate hike as being synonymous with these market moves," he said.

Knapp agreed with many economists that the discount rate move was largely symbolic, and he expects the stock market to continue to trade in a bumpy fashion until the market senses the Fed is ready to move its target Fed funds rate higher. The Fed, in fact, went out of its way to stress that the discount rate move does not mean it will soon raise its target rate, and that it does not expect tighter financial conditions for households and businesses.

"I think it's a choppy first half of the year. By the time, you get to the rate hikes, the market will get comfortable with how they're going to proceed," he said. For now, he said the market has been skittish about the idea of China withdrawing stimulus and the Fed pulling back on its programs.

"I think until we get to the point that the Fed is able to drain liquidity and hike rates, we're going to be between a rock and a hard place. I'd be stunned if it (the market) broke to new highs," said Knapp.

Knapp believes that the market will respond well during the first couple of rate hikes, as it has done in past cycles. Some investors fear higher rates will automatically hurt stock prices because they could make competing assets more attractive. But some analysts see a rising rate environment as a sign the economic recovery is gaining traction.

"Chances are before we get there, the Treasury market will continue to sell off and people will get a little worried about the Fed raising rates and sell the rally. We're within 5 bps of the high rate we made in December on the 10-year (close)," Knapp said. The 10-year was yielding 3.817 at its highest point Thursday.

After the Fed does move on rates, Knapp thinks the stock market will have a more sustainable rally. For now, he says it's best to be defensive. "We would continue to think more expensive cyclical sectors will be the ones that suffer the most," he said. He pointed to financials, materials and energy as sectors that "over shot" and they will struggle as liquidity is pulled from the system.

Stocks Thursday finished higher, and traded in a narrow range much of the day. The Dow was up 83 at 10,392 and the S&P was up 7 at 1106. The Nasdaq was up 15 to 2241, its fifth day of gains and longest winning streak since December. The best performing sector of the day was materials, up 1.2 percent, followed by industrials, up 1 percent and tech up 0.8 percent.

What to Watch

On Friday, investors will be watching the 8:30 a.m. release of the Consumer Price Index, which is expected to show a tame level of inflation at the consumer level. Also, New York Fed President William Dudley gives a speech in Puerto Rico at 8:15 a.m. The Mortgage Bankers Association will release its quarterly delinquency survey at 10 a.m.

Earnings reports are expected from Nestle, Brookfield Asset Management, J.C. Penney and PG&E.

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  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

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