Why markets may be setting up for a Yellen surprise

Markets are only half listening to the Fed, and that leaves room for a bigger reaction if Fed Chair Janet Yellen sounds as hawkish as the comments of some other Fed officials suggest she might.

"The market has shut them out. The market is only pricing a 50/50 chance of a hike this year. If they want to get this done, and they don't want to shock the market and create a whole repeat of last year's market volatility from not going [last September] … they have to inject the expectations of another rate hike. The best defense is a good offense," said Robert Tipp, head of global bonds and foreign exchange at Prudential Fixed Income.

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With little to sway the markets this week amid very light trading, markets are fixated on Yellen's Friday speech in Jackson Hole, Wyoming. The annual Fed symposium is sometimes used by Fed officials to make important policy statements. However, this year's topic is seen as a discussion for the longer term and is called "Designing Resilient Monetary Policy Frameworks for the Future."

Over the weekend, Fed Vice Chair Stanley Fischer joined two other recent hawkish-sounding Fed speakers, who were pushing the idea in speeches last week that the Fed is close to raising rates. Fischer's message was more on the economy, and he said the Fed is close to meeting its objectives, a comment taken as slightly hawkish.

"I think the confluence out there suggests that there must be a consensus across the Fed that they will get a rate hike done this year, if they can," said Tipp. "I think she will aim for the dovish hike. The problem with the dovish hike is I don't think you can do that in September. If you want to do so, a dovish hike is much easier in December. If you do it in September, you're going to have a lot of participants pricing in another hike in December." Tipp said the Fed wants the door to be open for a September hike, though it's highly unlikely it would act then.

"It's just not going to happen in September, in my opinion," said McCarthy. "If anything else, the Fed does not want to throw itself in the crosshairs of this potentially ugly presidential campaign one week before the first debate."

The dollar strengthened overnight Sunday and early Monday on Fischer's comment but by Monday afternoon, the dollar index was up less than 0.1 percent. Fischer is seen as a key member of the core of the Fed, along with Yellen and New York Fed President William Dudley, who said last week that the Fed could hike as soon as September.

"Once again it's a confusing message. On the one hand, they're telling us they may raise rates soon, but on the other hand monetary policy hasn't been very effective. We need help on the fiscal side. This is one of those times when we have to pay a lot of attention to the Fed, and whatever they say will be open to a wide range of interpretations," said Ward McCarthy, chief financial economist at Jefferies. McCarthy said Yellen may also sound somewhat upbeat on the economy, but she won't give a timeline on a rate hike.

There is little for markets to kick around Tuesday, with Markit manufacturing PMI at 9:45 a.m. EDT, new home sales at 10 a.m. and a few earnings from Best Buy, Toll Brothers, Intuit, J.M. Smucker and Bank of Montreal.

"When Dudley spoke last week, we got this little bounce [in the dollar]. It faded. Fischer spoke over the weekend. It bounced. Now it faded. The knee-jerk response is to buy the dollar. When all is said and done, we're talking about a December hike. That's not a sure thing. … It's hard to trade on these headlines," said Win Thin, senior currency strategist at Brown Brothers Harriman.

Stocks drifted on Monday, closing mixed on light volume. The Dow was off 23 at 18,529 and the S&P was down 1 at 2,182, but the Nasdaq was lifted with biotech, rising 6 to 5,244. Treasury yields were near lows of the day in late trading. The two-year was yielding 0.74 percent in late trading, off from an earlier 0.78 percent, in response to Fischer's comments.

"We have been here before and they haven't hiked," said Putri Pascualy, senior credit strategist and portfolio manager at PAAMCO. "We have been here before and they haven't hiked. In the event that the Fed does hike, knowing what they've done in the past, they're going to do it when they feel the fundamentals are strong."