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Markets expect friendlier Fed after it raises interest rates next week

Key Points
  • The Fed has become slightly less scary for the stock market, and traders are now pricing in a lower probability that it will raise interest rates even once next year.
  • The turmoil in financial markets has helped change expectations for the Fed, which Fed watchers say may now be more concerned about financial conditions after the more than 11 percent decline in stocks and a weaker world economy.
  • "The Fed's ability to surprise the market has kind of diminished. They've been so transparent. They gave us this playbook that they're going to follow," said one strategist. "They kept telling us they're data dependent and the data's getting a little softer. If you rank it on a relative scale of where the possibility of the greatest surprise would be coming from now, it's politics. It's not monetary policy for the time being."
Jerome Powell, Chairman of the Federal Reserve, speaking at the New York Economic Club on Nov. 181128.
Adam Jeffery | CNBC

The fear of the Fed is fading.

As the 10-week stock market correction deepened, fears of slowing growth escalated and expectations for Fed rate hikes have fallen. While stocks weakened, investors jumped into bonds, sending yields lower and igniting worries about a looming recession.

Odds are pretty low in the futures market that the Fed would raise interest rates more than one more time, though traders still expect the Fed to hike the fed funds rate by a quarter point next week. Stocks were bid higher Tuesday and closed higher Monday, after the S&P 500 bounced off its early October low, and tech rallied.

The S&P 500 is still down more than 11 percent from its September high. The easing of anxiety in markets was paralleled by a view that the Fed might be easier in its approach to interest rate policy. Optimism around trade talks boosted stocks Tuesday.

"To us the trade war and the Fed are the two biggest headwinds for the market," said Julian Emanuel, head U.S. equity and derivatives strategist at BTIG. "I think part of the reason we're not lower right now is that the market is starting to discount the probability of the Fed not moving next week."

Emanuel said the expectations for a hike, based on the futures market, were less than 70 percent. "If you're less than 75 percent, there's a good chance the Fed won't go," he said. While most Fed watchers expect a hike when the Fed meets Dec. 18 and 19, there is definitely a different tone in the market.

"They could just basically say: We're going to sit back, we're going to see how things develop, you fix China and those kinds of things," Emanuel said. Like many other strategists, Emanuel does not predict a recession next year, but the economy is expected to grow at a slower pace and the trade wars raise concerns that earnings growth could slow even more.

"The Fed's ability to surprise the market has kind of diminished. They've been so transparent. They gave us this playbook that they're going to follow," said Boris Rjavinski, director rate strategy at Wells Fargo. "They kept telling us they're data dependent and the data's getting a little softer. If you rank it on a relative scale of where the possibility of the greatest surprise would be coming from now, it's politics. It's not monetary policy for the time being."

Most Fed watchers still expect a December rate hike, but the fact that there is doubt about it shows the high level of anxiety in markets about both the economy and financial conditions, or the behavior of markets themselves. The fact that the November employment report Friday came in at just 155,000 payrolls, about 45,000 less than expected, also added to the sentiment that the Fed would have room to pause.

"You had this repricing with no new data, and the Federal Reserve officials are in the blackout period. The only new development was Brexit … and especially the increased probability there could be a hard Brexit," said Jon Hill, BMO fixed income strategist. He said expectations for a March rate hike dropped as low as 12 percent, before rising back above 20 percent Tuesday.

Hill said the market is now pricing in just 80 percent of one quarter-point hike for all of next year. It had been pricing in one full hike last week.

But with Fed officials sounding more dovish and concerned about global growth, the Fed as an issue has fallen into the background somewhat. The markets are still fearful trade wars will hurt growth, as could geopolitical uncertainties surrounding Brexit and the special counsel's investigation into President Donald Trump.

"It just feels like this is a time where people realize that political risks are of major consequence to the market, whether it's Brexit, France, the special counsel's investigation, the fact we now have a diplomatic skirmish with China as well as a trade war. You put it all together and it's a lot for the market to handle, particularly during a part of the year where the liquidity tends to become less liquid in terms of the holiday bias is beginning," Emanuel said.

Goldman Sachs economists, this past weekend, were among the latest to tweak their forecast for Fed rate hikes. They said there is now less than a 50 percent chance for a Fed rate hike in March, though they still see a 90 percent chance of a hike in December. They had previously forecast four hikes next year.

"The much more significant change is the sharp tightening in financial conditions. For a variety of reasons —including an initial bout of concern about [Fed Chairman Jerome] Powell's 'long way from neutral' remark, the inevitable slowing of GDP and profit growth from their exceptionally strong pace, and the broadening tension between the US and China — rising investor anxiety has pushed up our [financial conditions index] by about 80bp since early October. If the FCI remains constant at its current level, we estimate that tighter financial conditions would take ¾-1pp off real GDP growth over the next year," the Goldman economists wrote.

The Goldman economists had expected the Fed to raise rates four times, including March, and have forecast that growth would fall below 2 percent in the second part of next year. They now say it's possible the Fed will change its rate hike forecast, expected to be released after its meeting next week.

Powell was responsible for some of the change in tone after he said the Fed is close to neutral, contradicting a comment he made in early October that neutral is a long way off. Neutral is the level that would no longer be stimulative or slowing to the economy. A parade of Fed officials also sounded more dovish recently, including Fed Vice Chairman Richard Clarida, who has flagged slowing global growth as an issue.

"The Fed has been very sensitive to the elements of growth and the elements of weakness and vulnerability in our economy and the world economy," said John Stoltzfus, chief investment strategist at Oppenheimer Asset Management.

Stoltzfus said the market doesn't trust the Fed, however, and it continues to be a fear factor. "There still is fear of the Fed. Some have said the honeymoon is over with Jay Powell. There never was a honeymoon as far as I'm concerned. The market didn't trust [Ben] Bernanke for his whole term, and he was good to them. It didn't trust Janet Yellen. It was a leftover from the [Alan] Greenspan era, when the Fed wasn't transparent," he said.

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