Market Insider

How the Fed could pull a November surprise

Believe Fed is going to raise rates in December: Pro
Believe Fed is going to raise rates in December: Pro

The Fed meeting next week is widely expected to be a snoozer, but there is a way the Fed could wake up markets.

Fed officials have been suggesting a December rate hike is possible — including dovish New York Fed President William Dudley who is closely allied with Fed Chair Janet Yellen.

But how the Fed signals that it really is ready to hike for the second time in a decade next month is going to be important. 

Some market players believe the Fed will be fairly blunt in its statement next Wednesday, just like it was last year in late October when it injected the possible timing into its post-meeting statement. It said given the right conditions, it could hike at its "next meeting." Others believe Fed officials will not want to change the status quo, given the fact  the election, six days after the Fed meeting, could change the outlook if markets react wildly. 

"That's what they did a year ago. It's possible they could do that. I think the market already thinks that, but I think the Fed made it clear and that's what they expect to happen," said Ward McCarthy, chief financial economist at Jefferies. "I think the market would react somewhat, but at the same time, prior history suggests even with that type of pledge, some skepticism is warranted."

Ian Lyngen, head of U.S. rates strategy at BMO, said he expects the statement to include the phrase, indicating a stronger likelihood of a December rate hike. According to the futures market, expectations for a rate hike on December 14 are 74 percent, while November odds are 17 percent. 

"What they did in 2015 really sets up next week's meeting to be a more potentially tradeable event than the normal kind of sleepy event that we might have otherwise expected it to be. When you have an event where there's a large enough divergence of opinion, the price action surrounding the event can be decisive," Lyngen said.  "…They definitely lay the groundwork for a tightening in December at next week's meeting, and that definitely has bearish implications."

But the inclusion of that language could also be significant for what the Fed is signaling about itself. 

A promise to  hike in December could quiet dissent on the Federal Open Market Committee. At the  last meeting in September, three officials dissented and the view of the Fed has become that it's even more divided than it has been.

Diane Swonk, CEO of DS Economics, said she sees too much uncertainty for the Fed to point specifically to the December meeting for a rate hike. "If they do put it in, I think it would reduce the number of dissents. I don't think Janet Yellen minds having a pretty big showdown, even with her own vice chairman," she said.

She said Yellen's recent indication that it might be OK to let inflation overheat a little to give the economy more traction contrasts with Vice Chairman Stanley Fischer's view that the Fed runs the risk of causing an overheating that could hurt the economy.

"The last statement was nuanced. It would be nice if this was not nuanced and they say they're ready to go. You get a sense that the debate that's rising in the Fed is about more than a December rate hike. It's about going forward," she said. The Fed started this year expecting to raise rates four times, and now it is possibly going to raise just once. It also lowered expectations for next year. 

The Treasury market is already focused on next week's meeting, and there was some impact on Tuesday's $26 billion two-year note auction, which was softer than expected.  There is a $34 billion 5-year note auction at 1 p.m. EDT Wednesday and that too could see some pre-Fed meeting impact.

The two-year is the most sensitive part of the yield curve to Fed rate hike action. Tuesday's auction yielded 0.855 percent, and the bid to cover was 2.53, below the one-year average of 2.81 and the second weakest since December 2008, according to Peter Boockvar, chief market strategist at The Lindsey Group.

"Bottom line, a [two-year] note yield approaching a 4-month high didn't bring out the buyers. Yes, the Fed seems very intent on raising rates in December as they seem to be looking for every reason to do so and maybe that explains some of the hesitancy," Boockvar wrote in a note. The yield touched 0.86 percent, a level it was at last week but hasn't held consistently since June. Boockvar also pointed out that the two-year yield was at 0.95 percent when the Fed hiked last December, but that was when the market expected a series of hikes this year.    

Chris Rupkey, chief financial economist at MUFG Union Bank also expects the Fed to signal a December time frame.

"I think they would say 'next meeting.' When you have somebody like [Charles] Evans from Chicago saying he's OK with December, it sounds pretty much like it's a done deal, save the stock market falling a thousand points," said Rupkey. He said the market will be looking for any signal on how fast the Fed wants to move in the future on rate hikes.

Swonk said the election is one factor that will make the Fed cautious about tilting the statement too much toward December. "We have an election that's highly contentious. I don't think it's the same situation it was a year ago," she said.

Last year, the Fed included this line in its statement:

"In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments."

McCarthy said the market could react to a statement like that. "It could create a little volatility. The market is ho-hum ... so what if the Fed raises 25 basis points. What the market is more interested in is this mixed and muddled message that you're getting from all central banks that maybe they don't want the yield curve as flat as it is," he said.