The Fed Held Off, Now What? 3 Things To Watch For, If The Fed Is Going To Hike In 2016

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Summary

Divergent Expectations: The FED still expects two more hikes in 2016; The markets expect one.

Market volatility to increase as Brexit aftershocks unfold and FED officials adjust year-end rate expectations.

If the FED holds off in September, the dollar and equity markets will trade for a December hike.

As widely expected, the Federal Reserve has held interest rates steady at current levels, which now shifts the market's focus to economic data-watch, as investors try to anticipate the FED's next move.

Here's what the FED had to say about the U.S. economy since their June meeting; from the FED policy statement: "the labor market strengthened and economic activity has been expanding at a moderate rate."

Often overlooked by the market, the FED has a dual mandate, meaning their goal is to "foster maximum employment and price stability." Price stability simply means, inflation, which according to the FED appears to be under control: "Inflation has continued to run below the Committee's 2 percent longer-run objective."

What does this all mean? With inflation under control and economic data improving, the markets are expecting at least one FED hike before year-end.

Divergent Expectations:

It's important to remember, however, according to the FED's December projections for monetary policy, FED members expect a .9% Fed funds rate by year-end. If these expectations hold, we would see two rate hikes by December. And with only three more FED meetings this year, (September, November, & December), the FED would have to increase rates in two of those meetings.

Two rate hikes would undoubtedly be seen as very aggressive by the market since expectations are for only one more hike by year-end. As a result, look for increased market volatility in the coming weeks and months, and as the year comes to a close.

Key Indicators and Events to watch out for in the coming weeks:

1) An adjustment to FED expectations as officials talk down the possibility of two hikes in 2016.

2) Consistent positive economic data in the U.S., and stable crude oil prices; which helps to keep inflation under control; are necessary for the FED to remain hawkish.

3) Any Brexit fallout, such as an economic slowdown in Britain or the European Union, (E.U.) would cause the FED concern. Political uncertainty is also a possibility in Europe if other member countries decide to hold their own referendums as to whether to remain in the E.U. or the United Kingdom (U.K.). Any uncertainty surrounding the stability of the E.U. or the U.K. would likely force Janet Yellen & Co. to hold off hiking rates.

The longer the FED delays a hike, the higher the market's expectation of a hike at the following meeting. And since the FED is running out of time this year, the September 2-day meeting (on the 20th and 21st), should be a significant event. As a result, any economic data or global uncertainty between now and September 20th will likely lead to increased volatility in the equity, bond and currency markets.

Key Takeaways:

If the FED holds off in September, and with the unlikelihood of a hike in November; due to the Presidential elections; look for only one hike by year-end, during their December meeting.

A one-hike FED would typically lead to a stronger dollar, however, if the currency markets are pricing in two hikes, the dollar may sell off as investors search elsewhere for higher yields. Any dollar weakness is likely to be limited given the Brexit uncertainty and the slow economic growth in Europe.

The equity markets are enjoying a spike from the FED's July decision to do nothing and may do well if only one FED hike occurs by year-end. Although, equities may be vulnerable to any FED-speak signaling upcoming rate hikes in early 2017.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.