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Markets sniffing out inflation after Fed casts some doubt on its next move

  • Markets look to this week's jobs data for the next clues on Fed interest rate hikes.
  • ADP data is expected on private-sector payrolls Thursday, but the emphasis is on the wages number inside Friday's government employment report.
  • Three Fed speakers are also on the calendar Thursday, and jobless claims and international trade are among the economic reports expected.

The markets have turned to jobs data for the next clues about interest rates.

First, on Thursday, ADP releases private-sector payrolls for June, and that could be a warmup act for the big Friday government jobs report. However, markets are more clearly fixated on that government data and whether wages show much of an uptick, in any possible sign of inflation.

Inflation remains a hot topic in the market. The Fed Wednesday noted in the minutes of its last meeting that the drop-off in inflation was still a concern for some of its members, but it was mostly viewed as a temporary issue, reflecting "idiosyncratic factors." Any pickup in inflation could prompt speculation that the Fed could move sooner.

The fact that Federal Open Market Committee members also raised questions in the minutes about whether the Fed should barrel ahead with its plan to wind down its $4.5 trillion balance sheet cast some doubts on the path for interest rates. The market already has been doubting the Fed will be able to raise interest rates for a third time this year, as it has forecast.

"This introduces uncertainty into the timing of the next hike as well," noted Alan Ruskin, head of G-10 currency strategy at Deutsche Bank. But other market pros said they didn't see much of a change in the Fed's commentary and the economic data will be what drives rate decisions.

Market expectations are for the Fed to slow down the purchases of Treasury and mortgage securities by as much as $10 billion a month starting in September. The Fed is then expected to hike rates in December.

Some economists, though, expect the reverse sequence. They see the Fed raising rates first in September, and then taking action to taper back on the purchases of Treasurys and mortgage securities in December.

"I think the Fed minutes make clear that assuming the data is around in line, they're intent on shrinking their balance sheet," said Peter Boockvar, chief market analyst at Lindsey Group.

The Fed, in essence, purchases securities to replace those that are maturing on its $4.5 trillion balance sheet, which expanded dramatically with the Fed's quantitative easing programs during and after the financial crisis. The Fed has indicated it would pause rate hikes when it starts the balance sheet action, which is also expected to create some upward pressure on rates.

"We're going to get a form of tightening no matter what in September, whether it's a rate hike or quantitative tightening," said Boockvar.

The ADP report is expected to show 185,000 private sector jobs were created in June, while there are 179,000 jobs expected in the government's report Friday. Wages are expected to increase by 0.3 percent or 2.7 percent annually. Unemployment is expected to remain at 4.3 percent.

Some analysts say the Fed could feel compelled to move on rates if the unemployment rate continues to drop.

Leuthold Group chief investment strategist James Paulsen said, based on the minutes, the Fed is debating the speed of its balance sheet unwind. There are members that worry "if we overstay and this drives us below 4 percent unemployment, do we create a risk to financial stability by not acting," he said, "versus those that want to see more evidence that inflation is tracking."

"The reason it's important to me is if you get a string of weak data, or if you got a string of strong data, you could have the whole Fed shift pretty fast either way," said Paulsen.

"If it trended one way or the other for four to eight weeks, I think you would shift hard, not only toward a rate increase but also winding down the balance sheet," he said. "I thought they were going to do it but now it's a little more middling."

The Fed's minutes were from its June meeting, where it raised interest rates by a quarter point but also surprised the market with details of its balance sheet unwind. The Fed said it would cap the reduction in purchases at $10 billion for three months, then increase it if market conditions and the economy warrant.

There are also three Fed speakers Thursday. They include San Francisco Fed President John Williams, who speaks at 3:45 a.m. ET in Hobart, Australia, at the Economic Society of Australia. Fed Gov. Jerome Powell speaks at 10 a.m. at the American Enterprise Institute, and Vice Chairman Stanley Fischer speaks at a 7:30 p.m. event at the Martha's Vineyard Hebrew Center Summer Institute on Government Policy and Labor Productivity.

There is also oil inventory data at 11 a.m. Thursday. West Texas Intermediate crude futures slumped more than 4 percent to settle at $45.13 per barrel, on reports OPEC exports rose last month. But prices rose after API showed a bigger-than-expected decline in supply late in the day.

Watch: Cramer on future rate hikes