Careful What You Wish For: Why No Hike Tomorrow Could Devastate Markets

Ahead of tomorrow's much anticipated FOMC decision none other than Donald Trump has already chimed in on twice in the past 48 hours, "urging" Powell to stop hiking. However, this may be one of those cases where both the president and the bulls may want to be careful what they wish for.

First, recall what UBS fixed income sales specialist Dan Noorian said yesterday: should the Fed relent dovishly on the dot plot, and show a reduction in the path of rate hikes on Wednesday "fixed income markets won't react rationally, and the Eurodollar curve will invert further." According to UBS, the move could be made worse by accounts with limited tolerance for year-end losses stopping out of recent steepeners as "short the front end remains the dominant position."

In other words, while stock traders would like nothing more than for the Fed to halt its rate hikes, the knock on effect in fixed income could be dire as the result would be a violent covering in short positions, resulting in the dreaded surge in short-rate vol which then would spill over to the rest of the markets.

But what about tomorrow's largely priced in rate hike itself?

As we reported first thing, odds have been high that Jerome Powell will announce a quarter-point rate increase Wednesday, however those odds have been fading fast, and were down to 67.5% this morning according to the Fed Funds market, a number that is below the critical 70% threshold which the Fed needs to avoid "surprising" the market. 

There are other pressing questions: will the Fed execute a “dovish hike,” signaling a slowdown in the pace of future increases? Will it remove the phrase "further gradual" hikes indicating a full-blown pause? Will Powell address political pressure from the White House?

Commenting on how the Fed is trapped (as we first discussed yesterday), Terri Spath, a portfolio manager at Sierra Mutual Funds, told Bloomberg TV that "they’ve been backed into a really tough corner right now with all the noise coming out in the market as to what they should or shouldn’t do, and basically what they’re mandated to do."

At the end of the day it all boils down to this: will the Fed relent to Trump's demands and not hike, or will it engage in a "dovish hike", and after hiking tomorrow, pause indefinitely.

But while conventional wisdom may suggest that stocks will soar in a kneejerk response to a "no hike" - and they will might if only briefly - as Bank of America's CIO Michael Hartnett writes this morning, should Powell not hike, it would trigger recession concerns ("what does the Fed know") sending the dollar and Treasury yields soaring, while the resulting sell-off in rate-sensitives and cyclical stocks (watch RTY) would "prompt US stocks to join global bear market with SPX flush to 2400."

So is there something the Fed can do to avoid a market wipe out tomorrow? According to Hartnett, a "bullish Fed" would look as follows: "a 25bps hike plus message of "no inflation" allows pause in hikes and balance sheet tightening, b. US dollar falls, c. positive RTY, BKX, XHB reaction."