This is what Yellen could say that would change everything

The risk to markets Friday is that Fed Chair Janet Yellen simply sounds more ready than markets expect to raise rates for the second time in 10 years.

After listening to other Fed speakers Friday, traders were watching out for Yellen to go in the same direction - that the Fed could possibly still raise rates twice this year and as soon as September. Yellen speaks at 10 a.m. EDT.

"She could say we want to raise rates twice this year and the markets will get hit," said John Briggs, head of strategy at RBS. "The end game is the markets are going to take them out of September, if they signal it too strongly."

Already Friday, St. Louis Fed President James Bullardsaid September is possible for a hike but he sees a very slow trajectory for rate hikes. Atlanta Fed President Dennis Lockhart reportedly said that two rate hikes are possible this year, but one is more likely. And Cleveland Fed President Loretta Mesterreiterated that September meeting is "live" for a rate hike discussion, and that the economy is picking up in the second half of the year.

Markets are currently pricing about a 30 percent chance of a rate hike in September and roughly 55 percent odds for December, said Briggs. But the markets have not expected Yellen to signal rate hike timing at all.

If she does, the reaction could be strong. "The dollar will go up. Stocks will go down and financial conditions will tighten and they'll blink," Briggs said.

That would also snap Treasury yields out of their slumber and pressure emerging market currencies, and gold and other commodities.

But many strategists and economists say more likely is that she will sound dovish, and the reason may be that she will choose to address a more wonky academic question about long-term Fed policy rather than talk about what the markets want to hear.

Janet Yellen
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Janet Yellen

At the same time, the Fed's mixed messages, internal conflicts and pondering of longer-term issues have confused markets, and if she doesn't sound more confident on the economy, that may also create a backlash in the markets. The Fed has said it could raise rates twice this year, but the market barely expects one hike, at its December meeting.

"She's going to say what they've said before. I think the Fed's on track to hike this year, no real message on exactly when. Definitely, the market will be looking for things. I can't imagine her specifying a meeting, so she's going to give a boiler plate Fed statement. The more interesting thing will be the discussion on the sidelines among other members. Does the FOMC sound hawkish or not? Right now, you look at the Fed and there's a huge range of views there. They're grappling with the question of how well the economy can handle hikes and do they really want to hold the 2 percent [inflation] target now," said Ethan Harris, Bank of America Merrill Lynch co-head of global economics research.

The speech at Jackson Hole is perhaps one of the more widely anticipated chairman speeches outside of the financial crisis for the Kansas City Fed's annual symposium. It comes at a difficult time for the central bank, a time when market participants question the credibility of the Fed and doubt that global central bankers have any more fire power to fix the global economy. It's also a tricky time for the Fed, which could also easily find itself a political football during a contentious election year.

The topic of the conference is "Designing resilient monetary policy frameworks for the future" and Yellen's specific topic is, "The Federal Reserve's monetary policy toolkit." The Fed chair is expected to walk carefully between a dialogue about the Fed's policy tools and the current economic environment without tilting toward any current policy discussion. Yellen's speech will not be televised, nor is she expected to take questions following it.

"Yellen's speech has held the markets prisoner. They can't go anywhere." -Peter Boockvar, chief market analyst at The Lindsey Group

Stocks futures were mixed and flattish Friday. On Thursday were lower, with the S&P 500 down 2 points to 2,172. The dollar was lower against a basket of currencies Friday, and Treasury yields were flattish across the curve. The two-year was at 0.78 percent Friday after touching 0.80 percent briefly, and it is the most reflective of Fed rate hike expectations.

"The markets are catching their breath. It's been one heck of a post-Brexit few months. With Yellen talking and the jobs report coming up, there's a bit of a correction in the market place, but nothing extraordinary," said Krishna Memani, CIO at OppenheimerFunds.

An interesting market development ahead of the Jackson Hole speech has been the noticeably tight range of the 10-year Treasury yield, dragged lower with super low and negative global yields. It has been trading in a range between 1.50 and 1.59 percent for the entire month of August, as traders awaited the Yellen speech for some direction on monetary policy. It was at 1.56 percent Friday.

"Yellen's speech has held the markets prisoner. They can't go anywhere. They're in this little tiny space with bars around them, and they can't move until she speaks," said Peter Boockvar, chief market analyst at The Lindsey Group.

If Yellen surprises the market in a hawkish way, strategists say the 10-year could break out of that range quickly, and the two-year yield would also rise. "I do think Jackson Hole is a possibility. My general conclusion is that the market is fairly complacent for a good reason. The Fed has been remarkably inactive and has been very quick to become cautious at any whiff of worry," said Gene Tannuzzo, senior fixed-income portfolio manager at Columbia Threadneedle Investments.

Tannuzzo does not expect much from Yellen, but if she suggests an interest rate hike could be coming soon, then the market could react. Last week, New York Fed President William Dudley told reporters that it could be appropriate for the Fed to hike rates soon, including in September, while Fed Vice Chair Stanley Fischer said the Fed's objectives are close to being met.

"I don't really think there's any huge policy announcement coming at Jackson Hole, but if Yellen does start to take the side of recent commentators like Bill Dudley and Stan Fischer and says, 'The economy doesn't look that bad, and I think we could squeeze in an interest rate hike,' then I think the market could get pretty spooked," said Tannuzzo.

Odds for a September hike, based on the futures market, have been rising from around 20 percent last week to the current roughly one in three chance.

"The media has been trying to spin how all these Fed speakers are trying to talk up the chances of a rate hike, so we've gotten up to a 55 percent chance of a rate hike by December," said Briggs.

Fed watchers expect some of the discussion at the annual Fed symposium to focus on the longer term issue of what policy steps the Fed needs to take to deal with future crisis, after global central banks have gone to extraordinary lengths to ease policy and provide liquidity. One of those ideas was floated in a recent paper by San Francisco Fed President John Williams, who suggested the Fed may want to target a higher 3 percent inflation rate or nominal GDP. That confused some bond market players, who point out that the Fed has failed to reach its current target of 2 percent inflation.

Harris said the Fed could take action to raise its inflation target to say 2.5 percent, meaning inflation above the current 2 percent level would not trigger rate hikes. "That buys them more time for the economy to improve. It buys more time for other central banks to get their economics back to normal, and it means that the Fed might ultimately be able to raise rates more in four or five years out. It's a way of extending the expansion and allowing further time to heal. The Fed can't pretend it's alone in the world. In a normal recession, all the central banks cut rates together. The Fed could end up being on its own in the next crisis. This is about reloading the gun, so it's not about what they do in the next 12 months," said Harris.

Harris said by bringing up that discussion at Jackson Hole, the concept may not be understood. "That whole debate about 2 percent is making the Fed less clear. The people in the market are already confused about what the Fed's going to do. This is just adding a new layer of confusion into the market. Tell us what they're doing. She needs to talk more. I don't think this is the right vehicle. They need to start the discussion at the FOMC meeting," he said.

Critics of the higher inflation target suggest it would just extend easy policies that have not been able to give much lift to the economy.

"A new inflation target would undermine the Fed's commitment to any policy framework. It would please the denizens of Wall Street who pine for still-looser Fed policy. And households would be understandably miffed to receive a new lecture on unconventional monetary policy—this one on the benefits of higher prices," wrote former Fed board member Kevin Warsh in The Wall Street Journal. "A change in inflation targets would also add to the growing list of excuses that rationalize the economic malaise: the persistent headwinds from the crisis of the prior decade, the high-sounding slogan of 'secular stagnation,' and the convenient recent alibi of Brexit."

Tannuzzo said Yellen runs the risk of rocking the market more if she talks about the near term, and gets closer to discussing policy triggers. "The more she moves from the long term to a focus on short-term matters, like the … unemployment rate is low, wage inflation has been creeping higher … that becomes more hawkish. That could become more of an upside rate surprise," said Tannuzzo.

The Fed is swimming upstream against a flood of central banks cutting rates and extending asset purchases with now an estimated $13 trillion in negative yielding bonds thanks to central bank policies in Europe and Japan. But some market participants believe, as a result, the Fed will have a hard time taking the next steps toward normalizing policy because of that.

"The Fed wants to have it both ways. They want lower rates because they know that helps the economy. At this point, however, what they are really worried about is no inflation as much as that they are lowering volatility, leading to asset prices at a much higher level and causing all sorts of financial stability–related concerns. If the financial markets were at a 20 percent discount, I don't think they'd be as worried as they are," said Memani.