Economists and strategists believe the Fed will hike this week, but traders are betting strongly against it. Morgan Stanley said its readings on trading show a 30 percent probability that "overstates the chance" of a rate rise, while the CME FedWatch tool puts the probability at just 21 percent, down from 23 percent the day before and 45 percent a month ago.
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In 1999 and 2004, the central bank waited for market expectations to exceed 50 percent before moving, learning a lesson from 1994 when it tightened.
"The 1994 hike cycle was one in which the Fed did not sufficiently manage market expectations prior to liftoff," Dhingra and Hornbach wrote. "This resulted in a February 1994 rate hike that was followed by high levels of market volatility and a significant tightening in financial conditions."
Looking back at 1999, the Fed followed a fairly unpredictable path, hiking some months but holding pat in others, with moves correlating to a better than 50 percent chance in market pricing. Ditto for 2004, when the FOMC followed a path even more closely aligned with futures expectations.
Market reactions were significantly different between the three hikes: The 1994 move saw a sharp tightening, while conditions actually relaxed some after 1999 and "barely tightened at all" in the 2004 hike, according to observations Morgan Stanley used by following the Chicago Fed's national financial conditions index.
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Fed Chair Janet Yellen has stated repeatedly that the central bank would follow a "data dependent" course, meaning it would make sure not only economic data but also financial conditions were ripe for tightening. The economic data heading into Thursday's meeting is mixed though financial conditions already have tightened in recent days.
Morgan Stanley is putting its money where its mouth is, advising clients to stay long notes in the five- to 10-year duration and to anticipate a widening in the difference between yields on five- and 30-year U.S. government debt. The firm advises clients to use "steepeners," or derivatives, to play the yield curve between fives and 30s.
"In the current context, a market-implied probability of 30 percent seems to be below the minimum level where the Fed would like to see it, if they were to actually announce a rate hike in September," the Morgan Stanley duo said. "All else equal, if the market implied probabilities stay around current levels, the Fed might find it easy to pass on a rate hike at the September FOMC meeting."