Why London could decide the next US rate hike

The Fed sent a loud and clear signal that it would like to raise rates in June, but the decision may end up in the hands of the British.

The Fed's release of its April meeting minutes showed the Fed's discussion reflected more of the recent comments from Fed regional presidents, who have also been warning markets were not reflecting its intention to hike interest rates. However, the minutes started a new divide on Wall Street: Fed watchers who think the Fed will move in June and those who think the Brexit vote eight days after the Fed's meeting could hold them back. Brexit is the term for the U.K. vote on whether to remain in the European Union.

The markets had been bracing for a more hawkish message from the Fed, but its emphasis on June was an even hawkier surprise. "They were worried the market was underestimating a rate hike this year," said Mohamed El-Erian, Allianz chief economist. The Fed funds futures are now pricing in a 27 percent chance of a June hike, up from 4 percent a week ago.

Dove vs Hawk
Okea (l) | Vicky Hart (r) | Getty Images

"They are sending the clueless market a clue, make no mistake about it. A rate hike in June. Bet on it," wrote Chris Rupkey, chief financial economist at MUFG Union Bank. But others, including El-Erian, believe the Fed is really pushing the market to a different view — a rate hike is coming soon, but it's not exactly certain when.

"If you work backwards, we will definitely have a rate hike this year, maybe two. How early? July. Could it be June? Yes, but the polls for Brexit would have to give them a lot of confidence that British citizens will vote to remain," said El-Erian on CNBC. "It's hard to say between June and July, because they've got this massive Brexit vote on the 23rd."

BlackRock chief investment officer, global fixed income Rick Rieder told CNBC that Brexit could hold the Fed back. "In front of Brexit, I think it's a low probability," said Rieder. Sterling has been rising with new poll data showing that the anti-exit view is leading, but there have been other polls that show the opposite. The concern is that markets could become volatile going into and after the vote.

"Longer term, I don't think [Brexit] is an alarming issue for two reasons. One is it will be replaced with something else. Britain will have an association agreement with the EU," said El-Erian. "Second is Britain was never interested in the EU as an ever-closer union. It was interested as a free trade zone, so there was a different vision. In short, there will be uncertainty about what it will be replaced by and how quickly, so there will be short-term disruptions, but in the long term, I'm not an alarmist at all."

While Brexit has long been mentioned as a factor that could hold the Fed back in June, it is now rising higher up the list since some of the recent economic data has shown improvement. The Fed specifically mentioned June in its minutes, a strong message to the markets that the June meeting does have potential.

So, now the focus shifts to Fed speakers, who are still leaning on the economic data as the determining factor, but their words could help further shape the market view on timing. The Fed has forecast at least two rate hikes this year, while the markets had been expecting the first next year.

Fed watchers will especially be zoning in on the words of the key core Fed members, Fed Chair Janet Yellen, Vice Chairman Stanley Fischer and New York Fed President William Dudley. Both Dudley and Fischer speak Thursday.

"Dudley will be key," said Michael Hanson, senior economist at Bank of America/Merrill Lynch. Dudley, viewed as dovish, holds a press briefing on the economy at 10:30 a.m. EDT., while Fischer is speaking at 9:15 a.m. at an event honoring economist Michael Woodford at Columbia University. Yellen has an appearance at Radcliffe in May but on June 5, she speaks in Philadelphia at the World Affairs Council.

"On June 6, she's got a full-blown speech on the outlook and the global context that will be key. If something global is going to slow the Fed, that will be good time for her to make that point," Hanson said.

Hanson said he recently changed his expected timing on the next Fed rate hike from June to September. "We had thought June, up until a couple weeks ago, when the data softened, and the uncertainty was lingering. There was Brexit and all that stuff, and I felt the committee was going to let inflation overshoot," he said.

Besides the Fed speak on Thursday, markets will be watching closely when unemployment claims are released at 8:30 a.m. after last week's surprising jump. About 20,000 of the 294,000 were blamed on New York City schools' spring break by several economists. Expectations are that claims fell back to 272,000. The Philadelphia Fed survey is also released at 8:30 a.m.

Major companies reporting Thursday include Wal-Mart, Dick's Sporting Goods and Advance Auto Parts before the bell. After the close, Gap, Applied Materials, Ross Stores and Shoe Carnival report.

Stocks sold off after the Fed but ended the day flat. The S&P 500 rose less than a point to 2,047. Treasury yields continued this week's move higher, with the two-year at 0.88 in late trading after touching 0.92 percent. The Fed-sensitive two-year has been outpacing the 10-year, which was little changed at 1.85 percent.

"Don't go too crazy on the June rate hike. There's still a lot of hurdles and even if those hurdles are met, there's still a Brexit vote," said John Briggs, head of strategy at RBS.