Stocks on edge as Fed faces key decision on interest rates

U.S. equities went nowhere fast last week as investors geared up for Thursday, when Federal Reserve officials will announce if they are raising short-term interest rates for the first time since 2006.

The stakes are high. For the first time since before the Great Recession, the economy could be on the cusp of a hike in borrowing costs, ending the near-zero-percent interest rate policy put in place during the financial crisis as Fed policy makers sought to stimulate growth.

Or not. After a harrowing bout of volatility in late August, the futures market puts the odds of a rate hike at less than 30 percent, setting up a potential move on rates in October or December.

What happens next is anyone's guess, with ramifications for everything from mortgage rates to corporate earnings and foreign debt defaults, as a world that's grown addicted to cheap money faces the prospect of higher borrowing costs.

JPMorgan Chase(JPM) analyst Michael Feroli calls the decision about whether to hike in September "essentially a coin flip. Although the economic data "present a clear case" for the Fed to start normalizing monetary policy, the recent market turbulence could give policy makers pause, he said in a note.

His preference, in this environment, is for the Fed to hike rates while communicating that it's the pace of subsequent hikes that matter (the "pace vs. timing" message that Fed policymakers have tried to reinforce in recent months).

Put another way, the Fed should start pulling the punch bowl of easy money away before the party gets out of hand while preventing a panic.

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Technically, stocks are on edge forming a dangerous looking "bear flag" pattern that, if confirmed, would set up a retest of the August 24 "Black Monday" lows. This underlying weakness can be seen in the growing list of Dow Industrials component stocks that are rolling over again following the vicious short-covering rebound seen in late August. Just look at Caterpillar (CAT), shown above.

Societe Generale economist Aneta Markowska warned clients last week that no matter what the Fed decides this week, the outcome won't be dovish given that, as far as the economic data is concerned, the conditions for rate liftoff have already been met. Consider that:

  • The unemployment rate stands at 5.1 percent vs. the Fed's year-end forecast of 5.2-5.3 percent.
  • The economy bounced back to a 3.7 percent growth rate in the second quarter and is on track to be revised upwards to 4.1 percent based on more recent data.
  • Core inflation has stabilized of late.

Based on where futures odds are, the start of a tightening campaign would come as a surprise -- and surely rattle stocks. But Markowska warns that even a "no hike" decision could be hawkish because, in her view, the Fed will be forced to acknowledge recent progress in the job market and all but confirm an October rate hike.

Aside from the timing for liftoff, she believes Fed policymakers will stick to their guns on four anticipated rate hikes next year as revealed in the Fed's latest Summary of Economic Projections, or "dot plot" chart Currently, the futures market is only looking for three hikes next year.

In Markowska's words, the "only dovish scenario relative to market expectations would be a no-hike outcome, with the majority of the dots moving to the 0-0.25 percent bucket for [year-end 2015], essentially taking a rate hike for this year off the table. This is very unlikely in our view."

That's because "it would be difficult to justify postponing the liftoff by six months in the context of the cumulative improvement in the labor market," as well as the risk such a move would "significantly undermine the public's confidence and thus prove counterproductive."

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This improvement was illustrated by a stronger-than-expected July Job Openings and Labor Turnover survey last week.

The data, shown in the chart above, will make the Fed's justification of a "no hike" decision much more difficult. Futures traders, for their part, are betting with real money that Fed Chair Janet Yellen will find a way anyway.

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.