Financial markets have become the story for the Fed next week.
After another day of searing volatility, traders will look past economic reports Thursday and the normal triggers of market movements to see if conditions stabilize, creating an environment where the Fed would be more comfortable hiking rates for the first time in more than nine years.
"I think what people are going to focus on is are we in an extremely volatile period for the next couple of weeks, and if we are I think this is a Fed that feels like it can be patient," said Rick Rieder, chief investment officer, fundamental fixed income at BlackRock. He said the odds of a rate increase at the Fed's Sept. 16 and 17 meeting is now less than 50 percent, but would increase to 50 percent if the markets stabilize.
But Rieder said there may be too much emphasis on market conditions. "Clearly, it's one of the inputs into their decision, but it's not the primary influence," he said. "I think part of why the Fed's got a tough decision to make now is clearly the volatility and concern around growth has changed."
Wall Street is plainly split on whether the Fed will hike next week, with some saying the markets are already displaying enough volatility to sideline the central bank for several months or more. But most agree the markets have not priced in a rate increase, and there could be a violent reaction to whatever it does. CRT Capital surveyed 60 bond market participants, and 60 percent of those individuals expect a rate hike next week, while the futures market Wednesday was pricing in less than a 30 percent chance.
"They've talked about volatility so that's totally legitimate. That's what it comes down to. The economic data is good enough for them to raise rates. It's more about volatility in the financial markets that they're worried about," said Michael O'Rourke, chief market strategist at JonesTrading. If the S&P 500 holds 1,900, the Fed could hike, he said.
On Wednesday, the S&P 500 fell sharply, losing 1.3 percent to 1,942, reversing earlier gains of more than 1 percent on the day. It is now 9 percent below its May highs, and the Dow is about 11.5 percent off its highs.
"If we're above 1,900, the VIX would have come in and the market would have stabilized and that means we're unlikely to have hit a new low. Today's reversal is an ugly one, and it's a bearish pattern, so it will be interesting to see how the market digests this in the next couple of days," said O'Rourke. The VIX, a market fear indicator, rose 5.3 percent Wednesday to 26.23.
Bond yields came off their highs as stocks moved lower Wednesday. Rieder said stocks have become the barometer of volatility in world financial markets, while just two months ago, the bond market was more jittery than risk asset classes. Stocks tumbled with a nearly 4 percent drop in oil prices, and as Apple's much anticipated product announcements failed to excite the market.
The 10-year yield finished at 2.179 percent, after trading higher to 2.25 percent.
Another factor driving Treasury yields higher early in the day was the record corporate debt issuance, with 17 separate deals. That was the highest number of transactions in one day since 2010, according to Informa Global Markets. Yields rise as bond prices decline.
UBS rate strategist Boris Rjavinski said the recent increase in Treasury yields is also due to the fact that government debt issuance will be much larger in September than in August. Net supply has jumped from $15 billion in August to $67 billion in September, including TIPS and floating rate notes. The Treasury's auction of $21 billion in reopened 10-year notes was well-received Wednesday, and there is a $13 billion 30-year auction at 1 p.m. ET Thursday.
"I think the market needs to digest a big jump in supply relative to August. That could be a pretty big driver behind higher yields in the last few days," he said. Rjavinski said UBS expects a September rate hike, but the odds are close to 60-40. "It's far from a certainty. You put it all together. Some people think they will hike. There's big supply. The corporate issuance machine is restarting—and it's not shocking to see yields go higher," he said.
At Barclays, economists shifted their view away from a September rate hike last month.
"Our baseline is for March," said Barclays rate strategist Mike Pond. He said Barclays had thought the data was strong enough to justify a September rate hike, but it changed its view based on the numerous market measures that are pointing to a deterioration in financial market conditions.
"If those financial markets reverse course, we thought there was a possibility for September, but we don't think the data has been strong enough to offset the Fed's concerns about financial market stability," Pond said.
Pond said the central bank doesn't need the market to price in a higher probability of a rate hike for it to move off of zero rates for the first time in more than six years. "But we think the Fed would not want to surprise the market so it would have guided the market to price in a hike, or at least a better than 50 percent probability of a hike," said Pond.
Rieder said if the Fed does raise rates, the market will have a volatile reaction. He sees 10 percent odds for an October hike and 30 percent for December.
If the hike does come next week, "I think there's a tremendous amount of uncertainty that goes away," he said. "This is not a miraculous piece of news. I think once you get through the uncertainty, markets will have a tough time for a couple of hours, but then I think people will realize the world is not coming to an end, with a 25-basis-point move in the fed funds rate. I think it eliminates uncertainty. The markets hate uncertainty."
Analysts say Fed speakers will not be an influence for the markets as the FOMC meeting approaches since the central bank has entered a blackout period. Thursday's economic reports include weekly jobless claims data and import prices, at 8:30 a.m., and wholesale trade at 10 a.m. ET.