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Why the Fed could jolt markets

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Trading dovish Fed meeting

Market expectations may have gotten a little too high that the Fed will deliver a dovish message at the end of its rate meeting Wednesday.

Stocks rallied Tuesday on some stronger-than-expected earnings reports and higher oil prices, but equities also surged and the dollar weakened amid speculation the Fed could soften its message about rate hikes, due to market turbulence and a weaker economy. The central bank is not expected to raise interest rates at the meeting.

"The rhetoric around what they may or may not say has certainly coalesced around walking back four interest rates hikes in 2016," said Wunderlich Securities market strategist Art Hogan.

A trader works on the floor of the New York Stock Exchange
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The Fed and the markets have been at odds over the central bank's interest rate forecasts. When it raised rates for the first time in nine years in December, the forecasts of Fed officials pointed to four additional hikes for this year. As of now, the market is pricing in one and each piece of disappointing economic news has reinforced that view.

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But Fed watchers don't expect the central bank to budge on its rate hike view in the statement it is expected to release at 2 p.m. ET. The Fed is not holding a news briefing after the meeting, nor is it releasing new economic or interest rate forecasts until March.

"I think it's going to be tricky in the sense I don't think the Fed (officials) want to pigeon hole themselves into any one corner. On the other hand, they can't be tone deaf to what's going on. In September they talked about China and international developments as a reason to worry about financial conditions. If they gave us a statement that didn't acknowledge it now, they would be tone deaf, but I don't think they want to tip their hand as to what they're going to do in March," said Peter Boockvar, chief market analyst at Lindsey Group.

The market had expected a rate hike in March, but has since pushed out projections.

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Boockvar said the Fed will have to strike a balance in the statement, so that March remains in play for a hike. "I think they just want to be flexible. At the same time, they have to acknowledge what's going on here. They just can't say everything is fine. If they don't acknowledge it, they're going to be saying there's more rate hikes coming, and the market's going to have a tantrum," he said.

A too dovish statement, on the other hand, could calm markets and encourage the Fed to move forward with a rate rise at a time when the economy might be too weak.

"The reason we're selling off is not because of China, not because of lower oil prices, it's because the Fed is taking away the punch bowl," said Boockvar.

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The central bank could tweak its comments on the economic outlook, showing it's not as encouraging as it had been, and that household spending and business investment have slowed somewhat, according to Ward McCarthy, chief financial economist at Jefferies. He said the Fed could also acknowledge an even softer outlook for inflation, based on market-based measures.

"The Fed in my opinion is going to be as neutral as possible. They're not going to provide any hints whatsoever of what the timing of the next rate hike will be," said McCarthy. As for the worsening financial condition, "the Fed did not cause this. They are not going to own it. They're not going to take responsibility for causing it or trying to cure it. The problems lie elsewhere. The Fed is not going to be the balance sheet of last resort."

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Hogan said the Fed will likely point to the fact that its rate decision is data dependent and that it will give a nod to the financial turbulence.

Besides the Fed, there are dozens of earnings reports Wednesday including Boeing, Novartis, General Dynamics, Norfolk Southern, Fiat Chrysler, State Street and St. Jude Medical, before the bell. Facebook, eBay, Paypal, Qualcomm, Las Vegas Sands, Tractor Supply, Juniper Networks, Murphy Oil and Texas Instruments report after the close.

There are also new home sales reported at 10 a.m. ET. Oil inventories data will be released at 10:30 a.m., and could result in volatile trading after the American Petroleum Institute showed a build of 11.4 million barrels of crude in the past week. Oil erased its gains for the day on that report.

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