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The market's year is coming down to the Fed, but investors and Trump are likely to be disappointed

Key Points
  • The Fed is expected to raise interest rates by a quarter point Wednesday, while issuing a statement that strikes a dovish tone.
  • The Fed is also expected to lower the amount of interest rate hikes expected in the future and lower its outlook for the economy.
  • But some market strategists say the markets are way too optimistic that the Fed's comments will soothe stocks and help set off a rally.
  • President Trump is also likely to be disappointed, since he has said the Fed should end rate hikes and consider slowing its balance sheet reductions.
Federal Reserve Board Chairman Jerome Powell testifies before the House Financial Services Committee in the Rayburn House Office Building on Capitol Hill February 27, 2018 in Washington, DC.
Getty Images

The Federal Reserve on Wednesday may not be able to sound easy enough to satisfy expectations — including those of President Donald Trump who wants the central bank to stop raising interest rates completely.

So many investors expect the Fed to be dovish when it gives its highly-anticipated decision on interest rates that some strategists say there's risk of a negative market reaction because the central bank may just not be able to sound quite acommodative enough.

Some stock strategists have been hoping the Fed would provide a catalyst to reverse recent losses, even if it does raise rates, as expected.

"Investors are close to extreme bearishness," notes Michael Hartnett, Bank of America Merrill Lynch chief investment strategist. "All eyes are on the Fed this week, and a dovish message could equal a bear market bounce."

The S&P 500 rolled over on Tuesday and closed up less than one point, after attempting to rally after Monday's steep losses. With the benchmark down about 5 percent for the year, there is mounting pressure on the Fed to give a nod to the volatility in the financial markets.

The consensus view is that the Fed will raise interest rates Wednesday by a quarter point — a hawkish signal. But the Fed should also immediately temper that tone by reducing its forecast for future interest rate hikes, eliminating at least one hike for next year. The Fed is also expected to reduce its forecast for the economy and possibly lower its inflation outlook, while emphasizing that future policy move will depend on the strength of the economy.

"Equities are hoping that the Fed is almost done or [for] signals that they're going to pause. I think it's too premature for them to do that," said George Goncalves, head of fixed income strategy at Nomura. "The Fed was a little too optimistic for next year, and now they've got to come down. The recent price action is almost an overshoot on the bearish side."

Trump has made it clear, in tweets and comments, that he would like the Fed to stop raising rates altogether.

"They're going to have to change their view, not because they're reacting to pressure that's coming from the president, they're going to keep emphasizing their independence," said Goncalves. "It's in many ways because financial conditions have weakened, that's the catalyst...not because of the pressure."

$50bs

Trump, in a tweet Tuesday, told the Fed to 'stop with the $50bs' which market pros took to mean the Fed's program to reduce its balance sheet by $50 billion a month. The Fed does that by reducing the reinvestment it has been making as the Treasurys and mortgages on its balance sheet mature.

Market turmoil, low inflation and signs of slowing in the world economy have combined to quickly change the market's view from one where it was expected the Fed would raise interest rates this week and then twice next year. Expectations are about 70 percent in the fed fund futures market for this week's rate hike, but just about half of a rate hike is priced in for next year, down from two full hikes. The Fed forecast was for three hikes next year.

"The Fed is all but priced out at this point. We have less than one rate hike priced for next year," said Jim Caron, fixed income portfolio strategist at Morgan Stanley Investment Management. Caron said one of the more dovish things the Fed could say would be that it is slowing the unwind of its balance sheet, as Trump suggested, but he does not expect the Fed to address that until next year.

The Fed's September forecast included the three hikes for next year, but it could cut that to two or even one rate hike. "These are levers they can pull, and it really is an event day. Many of the other Fed days, we knew what they were probably going to do. We knew what they were going to say. This time, we really don't know. That's what makes it so anxiety ridden. I think the anxiety is the Fed just disappoints the doves," said Caron.

Needs to show independence

If the Fed were to give Trump what he wants and hold off on rate hikes, the market reaction could turn violent..

"The only way they could be more dovish is not to hike, but that would be more disruptive. That would be worse. They can hike and sound dovish, but I'm not sure they can sound dovish enough. To be really dovish, they almost have to list what things would make them stop," said Goncalves. The Fed could also indicate it is not going to hike in 2020, and that would be taken as very dovish.

"I'm not sure they are ready to throw in the towel," he said. "If they do it, they'd basically be very dovish. That way they admit that after next year it's over."

Fed watchers say the Fed is not likely to react to Trump. "From the Fed's perspective, he's not part of the discussion so I think they try to stay as far away from him as possible," said Caron.

Caron said the market reaction could be sharp, and yields could rise if the Fed sounds less dovish than expected. Yields move opposite price.

"If the Fed is dovish yields go down. If they talk about slowing the pace of their balance sheet reduction, yields go down," Caron said.

The Fed will have to walk a fine line between being so dovish it spooks the market, but the U.S. economy is still strong and the labor market is extremely strong, making it difficult for the Fed to sound too dovish.