Why Markets aren’t Prepared For The Fed

If the Fed hikes next week, we firmly believe that officials have made a huge mistake. But what's really expected of Yellen & Co remains up for debate. Markets remain choppy overall as the Australian dollar led the way in an impressive performance while the yen and dollar lagged. The Asia-Pacific schedule is mum. A new Premium trade has been added, which was last brought in early June for an  eventual +500-pip gain. Five charts were added with the trade.   The chart below shows the performance for the major global equity indices since the famous bottom of March 2009.

The widely-quoted statistic on what's expected from the FOMC are Fed funds probabilities. At the moment, they show a 28% probability of a hike. Economists meanwhile, have shifted their calls away from a Sept hike but more than 50% still see liftoff next week.These kinds of divergences take place periodically and almost universally, we stick with what the market is saying. But it's not quite black-and-white this time.

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Fed fund measure the effective rate and the 28% chance of a hike assumes that rates will average 0.375% after the hike (that's the midpoint between 0.25% and 0.50%). But there's a reason the Fed is sticking to a range and not a target. Officials are worried they won't be able to meet a target and all indications are that it's the lower band they're worried about.

There is $2.5 trillion in cash parked at the Fed and much of it isn't eligible to earn the overnight rate (like local branches of foreign banks). That money will chase down rates and that's why the Fed has been testing term reverse repos. Once the hike is unleashed, those plans will go into action but there is no guarantee of success, especially in the early days.

So we're open to the possibility that the real implied probability of a hike is somewhere between 28% and 50% but that number isn't necessarily critical. What's more important is whether the Fed can actually hit the midpoint. If not, that might be a better reason for volatility than a hike alone.

We'll have more on this theme in the days ahead but for Thursday, the theme was US dollar weakness as soft import prices and inventories weighed. The Australian dollar was especially impressive as it rallied almost 1.5 cents from the session lows. If Chinese markets can remain stable into the weekend, there is potential for more.