What two Fed rate hikes could mean for markets

While consensus for the first U.S. Federal Reserve rate rise is leaning towards September, a growing number of market watchers are suggesting that, before the year is out, two interest rate hikes rather than just one could be on the cards.

The Fed will meet Tuesday and Wednesday for its closely watched Federal Open Market Committee (FOMC) meeting and the statement that follows. While policy makers are not expected to make any major decisions this week, investors will be looking for hints on the Fed's timing for possible future rate movements.

Federal Reserve Board Chair Janet Yellen testifies before a House Financial Services committee hearing on Capitol Hill in Washington, July 15, 2015.
Yuri Gripas | Reuters
Federal Reserve Board Chair Janet Yellen testifies before a House Financial Services committee hearing on Capitol Hill in Washington, July 15, 2015.

A number of officials from the central bank have already suggested that two rate rises are possible this year, but economists and investors assessing the economic data are now also leaning in favor of two hikes.

"Yellen has always said that when wages go up between 4 and 5 percent that's when we raise rates," Paul Donovan, global economist at UBS investment bank told CNBC, referencing employer costs for employee compensation data from the U.S. labor department, which is now growing at 4.2 percent year on year for wages and salaries.

"This is going to be a very gentle, gradual trajectory, but I think they hike in September and I think they hike in December, I expect two hikes this year. Remember inflation really is picking up in the U.S. in a reasonably notable way, it is going to be coming in comfortably over 2 percent at the start of next year," he said.

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Behind the curve?

Earlier this month, San Francisco Fed President John Williams said his preference would be for two rate hikes before the end of the year, echoing comments he made in June.

Meanwhile, Fed governor Jerome Powell also said he was prepared to raise interest rates twice this year in September and December as long the economy continues to perform as expected. The Fed has kept interest rates near zero since late 2008.

"My base case is they hike in September, with two hikes before the end of the year. The market is not really fully priced for that, so a hike in September will be dollar positive," senior foreign exchange strategist at ANZ, Khoon Goh told CNBC.

"I think for September, the market is only about 10 basis points priced in, "meaning a large portion of the market are not positioned expecting an interest rate rise," Goh said, which could push the dollar index against a basket of currencies above the 100 level, up from its current levels of 96.5.

Underestimating the rate cut

In the U.S. Treasury market, futures contracts suggested that investors were "making the same mistake they made at the outset of the last three major tightening cycles", by underestimating the amount the federal funds rate will be raised.

"We think the Committee will raise the rate faster and further than most anticipate in response to higher inflation and that this will drive up the 10-year Treasury yield significantly," chief markets economist at Capital Economics, John Higgins said in a note to clients on Monday.

Capital Economics forecast suggest the funds rate will be in range from 1.75 percent to 2 percent in September 2016, whereas the implied rate of the current futures contract is around 0.8 percent.

"Admittedly, this implied rate, and those implied by the prices of other financial market instruments, may be distorted by uncertainty about the path of monetary policy. But our end-2016 forecast for the rate (a range of 2.25-2.5 percent) is still significantly higher than the latest median projection of FOMC participants (1.625 percent)" Higgins said.

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In terms of when the Fed usually starts to hike rates in economic cycles, Donovan said this time around the central bank is "very, very" late in raising rates, which could become a worry to markets if inflation continues to pick up.

"I actually think it (the Fed) may be a bit behind the curve, I think the markets might start to worry about this, as the gap between the core Personal Consumption Expenditure deflator (the Fed's monitor of inflation) and CPI (consumer price index) (what the market watches) starts to widen," Donovan said.

"I think the market might start to think 'you know perhaps you should have started to hike sooner' and we might actually see that coming into a bit of the pricing," he added.