How the Fed could challenge markets

Markets are ready for the Fed to bring on a quarter-point rate hike after seven years at zero, but it's the nuances in its statement and forecasts that could be more challenging.

"The consensus view around the world seems to be it will be a dovish hike, and it will be, relative to history, but it may not be relative to what are now very high expectations that it will be dovish," said Tony Crescenzi, senior vice president and Pimco portfolio manager.

The Fed is expected to raise the fed funds target rate Wednesday and release economic and interest rate forecasts with its 2 p.m. ET statement. Fed Chair Janet Yellen then briefs the media at 2:30 p.m.

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One key will be in the Fed's forecasts for interest rates, which are displayed in a chart known as the "dot plot."

"It may not have the dovish hike feel to it that some want, mainly because the summary of economic projections and the dot plot will seem to indicate there's a reasonable chance for more (hikes)," said Crescenzi. "The dots are positioned for three to four, and the market is positioned for two to three. It may seem out of sync with the dovish hike view."

George Goncalves, head of U.S. rate strategy at Nomura, said the bond market will certainly react to the rate forecast. If Fed officials lower their forecast to just two rate hikes, that would be bullish for bonds, and three would be slightly less bullish. "If they stay, the bond market would sell off," he said.

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"I think they'll try to convey the message that this is the beginning of a process that's going to take a long time and is very slow. they don't want the market to freak-out that this is going to be a Greenspanian 25 basis points every-six-weeks hike. I think we'll only get two hikes next year," said Jefferies chief financial economist Ward McCarthy. He was referring to the rate hike policy under former Fed Chairman Alan Greenspan.

"The message used for tomorrow's action is "dovish tightening," which is an oxymoron. I think the Fed will do what they have to do and try to take as much sting out of it as possible," he said.

McCarthy said there's plenty of opportunities for the markets to mistake the Fed's message. "There's just too much information they're trying to convey. I think there will be confusion and consequential volatility, but when the dust settles I think bonds will be little changed and I think stocks will be higher," he said. As for the dollar, "I think that's a pretty crowded trade. It wouldn't surprise me if the dollar is lower initially. But I do think as time passes, there's still upside."

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If the Fed message is dovish, the stock market could see more gains, and ride a "Santa rally" into year end.

"What we think is going to happen is the message that the Fed is going to send out tomorrow is going to resonate positively with the investing public," said Julian Emanuel, equities and derivatives strategist at UBS.

The Fed's message will be: "The economy is OK ... we're still not going to raise aggressively enough that the economy is threatened in any way shape or form," he said. "We think they're going to do a good job of messaging."

Randy Frederick, managing director, trading and derivatives at Charles Schwab, agreed that the next path for stocks near term could be higher after the rate hike. Shakiness in the stock market last week and widening credit spreads had created some speculation the Fed would hold off on the rate hike, but the futures market indicates high odds of a hike.

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"I think that everybody is so ready for this. The market would sell off if they decided not to do it," he said.

"My belief all along has been it's a positive for the market. There's a potential for a very sharp rally for the market in the last two, three weeks of the year," said Frederick.

Stocks rallied about 1 percent Tuesday, as oil prices fell and traders anticipated a Fed rate hike. The S&P 500 rose 21 to 2,043.

The Fed is also expected to tweak the language in its statement to reflect the improvement in employment and it will touch on inflation, which has been lagging.

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"I think they'll upgrade their language around the labor market, and the job market is closing in on full employment," said Mark Zandi, chief economist at Moody's Analytics. "If not in the statement, certainly in the press conference, Yellen will make the point that wage growth is firming, consistent with the idea the economy is getting to full employment. That will be essential to their case. I think they'll say core inflation is bottoming, and it will start to move higher consistent with tightening in the labor market. And the transitory effects of lower oil and the stronger dollar will fade."

Zandi said the markets have been preparing for the rate hike, and the reaction to the Fed may be muted. "One reason why the stock market has gone sideways this year, why the dollar is up so much, why commodities prices are down, credit spreads are gapped out — the markets are digesting the reality of this and they've been doing so for quite some time," he said.

The Fed will also announce some operational details on how it plans to raise the fed funds rate. It is expected to disclose how much capacity it will have in its overnight reverse repo operation, a collateralized lending program. Currently, the facility is $300 billion but estimates range from about $500 to about $800 billion, and the Fed could also temporarily remove the cap.

Under the program, institutions lend cash in an overnight operation to the Fed at a certain rate, which is expected at 25 basis points, the low end of the new target rate range, in exchange for securities. The transaction is then reversed.