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Fed's move on rates still a close call

Whatever the Fed does in the week ahead will surprise about half of Wall Street—and that could mean an extra dose of volatility in already rocking markets.

Based on the futures market, traders were betting as of Friday that there's just a 25 percent chance the Fed will move off its zero rate policy for the first time in more than six years. But Wall Street's economists are closer to evenly split on whether the central bank will announce a rate hike Thursday, after its two-day meeting.

"To me, there's great volatility whether they do it, or don't do it," said James Paulsen, chief investment strategist at Wells Capital Management. "That's what I find interesting about the Fed decision. If they say they are waiting they're going to create volatility. If they don't go on Thursday, there's going to be volatility."


Traders work on the floor of the New York Stock Exchange.
Brendan McDermid | Reuters
Traders work on the floor of the New York Stock Exchange.

There is little else traders are focused on in the week ahead, though weekend economic data from China and the prospect of another debt ceiling battle in Washington are getting attention. There are a few U.S. reports the markets will watch ahead of that Fed meeting, including August retail sales Tuesday and CPI consumer inflation data Wednesday.

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Ironically, the markets themselves are viewed as a potential catalyst that could delay the Fed action, with some economists pointing at financial conditions and the potential for further fallout from China and other emerging markets. They also make a case for the Fed to hold back, since the markets are not pricing in an anticipated rate hike.

"Whether the FOMC raises rates at next week's meeting is a very close call—we view it as essentially a coin flip," wrote JPMorgan economists.

"Shouldn't be close," said a Goldman Sachs note. "We do not expect a rate hike at the Sept. 16-17 FOMC meeting."

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This divide among economists is also playing out in the markets, and Paulsen said the Fed is responsible for a backdrop of volatility. He also said the central bank should move just to preserve its credibility.

"They made this mess ... if there's volatility because of it, it's already a reflection of the Fed overwaiting. ... You think if you push this forward two or three months, Wall Street won't do the same thing again? Every time it comes up, Wall Street is going to react. It's kind of self-created volatility," he said.

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Peter Boockvar, chief market analyst at The Lindsey Group, said the Fed could drive stocks immediately higher with its actions, whether it hikes or not.

"My sense is nothing happens until 2 o'clock Thursday, and I think if they hike and sound very dovish, or if they don't hike, in those two hours we could have a good rally. If they don't hike, we'll have a bigger rally," said Boockvar.

What is less clear, however, is what happens the next day after the Fed's 2 p.m. statement Thursday and its 2:30 p.m. ET news briefing. "If they don't hike, this is not a good thing. We're past the point of Fed easiness being good for markets. If they do hike with the fed funds futures only pricing a 25 percent chance of it, I think you could have a big dislocation."

Boockvar said he expects stocks to sell off after the immediate pop. "I think you sell that rally. People are going to realize the Fed has no bullets," if it doesn't hike, he said. "If they don't raise rates and they're very dovish, I think the dollar is a sell on the news," he added.

George Goncalves, head of rates strategy at Nomura, said he does not expect the Fed to move yet but if it does, and it sounds extremely dovish, it may not hurt the markets or be disruptive. The two-year yield was at 0.70 percent late Friday, and the 10-year was at 2.19.

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"If they were to hike and they make it seem like it's only more of an operational thing and they are very dovish in how they communicate ... if they really go out of their way to make it a so-called dovish hike, I think the markets would take it in stride but there would be an adjustment mostly in the front end of the yield curve. Money markets would have to take a pause and recalibrate but the overall bond market would take it in stride," he said.

"If it's a dovish kind of hike and they're going to go slower that should be favorable for the five-year, 10-year part of the curve. The 30-year could start to get volatile because that's where inflation fears would show up the most."

Stocks in the past week closed higher, with the Dow gaining 2 percent to 16,433, for the best week since March 20. The S&P was up 2 percent to 1,961 in its best week since July 17.

Paulsen said he expects stocks to take another run at the August lows, even if there is an immediate bounce on the Fed this week.

"I think we're going to go back and challenge those old lows at some point, and I think we fail. My guess is (the S&P 500) breaks 1,800. We need to get to a lower valuation foundation, which we really haven't done yet," he said. "If it just goes right back up, we still have all the same challenges we had before. We've got to bring valuations down, and we need to scare people. I don't see fear."

September is a typically weak month for stocks, and the S&P 500 is now down 4.8 percent year to date. According to Jeff Hirsch, editor in chief of the Stock Trader's Almanac, the first half of September is usually better for the market than the back half. He said the coming week is the triple-witching expiration of futures and options, which can bring its own volatility. But historically, it is the week after September triple witching that is very weak.

"The week following has been down 21 of the last 25 years," he said.

Tuesday

8:30 a.m.: Retail sales

8:30 a.m.: Empire state survey

9:15 a.m.: Industrial production

10 a.m.: Business inventories

Wednesday

FOMC meeting begins

8:30 a.m.: CPI

10 a.m.: NAHB survey

4 p.m.: TIC data

Thursday

Final day of FOMC meeting

8:30 a.m.: Initial claims

8:30 a.m.: Housing starts

8:30 a.m.: Current account

10 a.m.: Philadelphia Fed survey

2 p.m.: Fed statement

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

Friday

10 a.m.: Leading indicators

Saturday

1:30 p.m.: San Francisco Fed President John Williams on the economic outlook

3:30 p.m.: St. Louis Fed President James Bullard on the economy and monetary policy