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If you're watching the Fed, you better pay attention to this instead

Everyone's waiting for the Federal Reserve in the week ahead, but the real action may be coming out of Tokyo.

The Fed meets Tuesday and Wednesday, and so does the Bank of Japan. The Fed is expected to hold off on an interest rate hike until December, though more members of the Federal Open Market Committee clearly favor raising rates, so the Fed forecast on both rates and the economy will be important.

"I don't think they're going to go, particularly given the recent data that's been softer. I think they're going to wait until December," said Rick Rieder, chief investment officer, global fixed income at BlackRock.
"Markets today are pricing in about an 18 percent chance that they go. But they're also pricing in December at 50 percent. I think December is higher than that. I think it's a 60 to 65 percent chance. I think they want to go."


But the Bank of Japan is another story, and it's expected to take some action, which will be announced in the early morning hours of Wednesday. Speculation points to a possible interest rate cut deeper into negative territory, tweaks to its assets purchase program or new rules on the duration of securities it will purchase in the bond market.

"I think the Bank of Japan is very important. They could change the amount [they purchase] to a range. I think people could view that as tapering, which I don't think they're going to do," said Rieder. He said the BOJ could stop buying bonds at the long end of the yield curve, which means long end rates could rise while shorter term rates remain negative.

In the U.S., long end rates affect corporate borrowing, and 10-year yields affect corporate borrowers and mortgage rates.

Japan's heavy use of policy has not delivered the desired results, and the stronger yen has defied the central bank's efforts. So equally interesting to markets could be an appearance by Prime Minister Shinzo Abe, who will discuss his economics program with investors Monday morning in New York.

"I think the Bank of Japan is very comfortable with the yield curve steepening. The steepening helps their banking system, helps their insurance companies. I think they're covered with the yield curve because it looks like their policies are working," Rieder said. That type of move in Japan could spill over to a steeper curve in the U.S. too.

The BOJ and the European Central Bank, for that matter, have been key drivers of the long end of the U.S. Treasury market, which pulled in buyers from overseas as investors looked for alternatives to the low and negative yields in Europe and Japan.

Just reports that the Bank of Japan could stop buying longer duration securities drove Japanese bond prices lower, and that spilled into the U.S. bond market in the past week. Prices move inversely to yields. Before retreating, the U.S. 10-year note temporarily reached a high yield of 1.75 percent, and the 30-year hit 2.50 percent, both the highest levels since June.

Amherst Pierpont chief economist Stephen Stanley said he sees the Bank of Japan meeting this week as potentially more important than the Fed.

"The BOJ promised a major report on the course of monetary policy at this meeting, and market participants have been speculating wildly on what policymakers in Japan will do next. The BOJ faces a similar problem as the ECB, as QE is apparently not working very well in generating growth or inflation, and the central bank may be running out of government bonds to buy. If the BOJ decides, as the ECB did, to merely maintain the status quo, speculation that central banks globally have run out of ammunition will likely intensify," Stanley wrote as a note.

Central banks have been criticized for potentially creating a bond bubble and over-inflating equities prices with all of their easing. But the Fed is expected to take very slow steps toward hiking, and the ECB and BOJ, still in easing mode, will not be moving off of easy monetary policies any time soon.

"Some of the correlations between rates and equities are changing. I think it's a big deal if the Fed can start to move. You lose some of that benefits of rates being your ballast against risk assets," Rieder said. He also said a move to raise rates by the Fed could affect the billions in risk parity trades, which are basically a bet that both stocks and bonds are going higher in a low rate environment.

The Fed has been stirring up markets with rate hike speculation in a big way since late August when key Fed officials said they could raise rates in September. But ultimately it was some dovish Fed members and a string of soft economic data that convinced markets the Fed will stay on the sidelines.

"I think what makes it difficult for everybody is if you go through the speeches, and see who has come out among the voters and said they're ready to raise rates, the majority of the voters have articulated that they are comfortable with rates going higher, but I still think the committee will not do that," Rieder said.

Stocks in the past week closed higher, with the S&P 500 up a half percent at 2,139, and the Dow was up 0.2 percent at 18,123. The Nasdaq outperformed, gaining 2.3 percent for the week, the most since July, thanks to a more than 11 percent gain in Apple and strength in the semiconductor sector.

Don Townswick, the Director of Equities at Conning, said he's looking past the Fed in the coming week.

"I think the focus on the Fed and interest rates borders on mania. There are a couple of different things we should be focused on as we approach the election. The candidates' economic programs are coming into more focus," he said. Townswick said the market favors Democrat Hillary Clinton because she is more predictable than Republican Donald Trump.

"The election, I think, will be good news in the sense that it will take away the uncertainty, no matter who wins. I think in terms of purely policies, the latest stuff I've heard sounds like for the economy, Trump's fiscal proposals are better, but if he starts a trade war, that's not good," said Townswick.

Townswick said he's focused on the release of second-quarter GDP in the following week, and also earnings warning season.

"I hope we get an upside surprise and upward [GDP] revision the week after next, but I fear we won't. If earnings are supposed to strengthen, and we're supposed to see more strength in the second half of the year, that's going to be a critical report," he said.

"The market right now, at these levels, with earnings where they are, and interest rates whey they are, I think that the market's going to trade in a range for the next several months, almost no matter what data comes out," he said. But the market could break out if there's a solid revision to GDP, followed by better earnings.

What to Watch

Monday

Earnings: Ascena Retail

Tuesday

2-day FOMC meeting begins

Earnings: Lennar, FedEx, KB Home, Adobe Systems

8:30 a.m. Housing starts

8:30 a.m. Building permits

Wednesday

Earnings: General Mills, Red Hat, CarMax, Bed Bath & Beyond

2 p.m. FOMC meeting statement and economic projections

2:30 p.m. Fed Chair Janet Yellen press conference

Thursday

Earnings: AutoZone, Rite Aid

8:30 a.m. Initial claims

9 a.m. FHFA home prices

10 a.m. Existing home sales

10 a.m. Leading index

Friday

Earnings: Finish Line

9:45 a.m. Manufacturing PMI

12 p.m. Philadelphia Fed President Patrick Harker, Atlanta Fed President Dennis Lockhart and Cleveland Fed President Loretta Mester on reinventing communities, transforming economies

12:30 p.m. Dallas Fed President Rob Kaplan speaks at energy forum