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Surprise Fed Speech Throws Markets Into Most Volatile Day Since July

Those figuring that the Fed still might hike rates in September are getting one more bite at the apple.

As the week drew to a close and the Fed's "quiet period" before meetings was about to settle in, investors recoiled over news that the central bank's most dovish official, Governor Lael Brainard, would be delivering a previously unannounced speech Monday at the Chicago Council on Global Affairs.

The news sent a chill through markets Friday, with major stock market averages taking a beating and short-term government bond yields and the U.S. dollar moving higher, and it set off yet another round of speculation over whether the Fed is ready to come off its historically loose monetary policy. The S&P 500 was down more than 1 percent Friday afternoon, on track to close with its biggest percentage move since July 8. The Dow Jones industrial average fell about 300 points lower.

"When a market is quiet, it's susceptible to rumors, whether we're talking about a path to freeze oil production or whether the Fed is going to raise rates in September," said Quincy Krosby, market strategist at Prudential Financial. "This may be a market that has too much time on its hands right now."

"When a market is quiet, it's susceptible to rumors."

Indeed, the guessing game over whether the Fed might enact its first rate rise since December and only its second tightening in more than a decade has set off a fever pitch of horse trading.

At one point Friday morning, markets put the chance of a hike later this month as high as 30 percent before backing off. The probability had been reduced amid a week's worth of poor economic data, including the worst services reading in six years, a contraction in manufacturing and a weaker-than-expected nonfarm payrolls report.

Read More From CNBC: Stocks Sell Off as Fed Fears Loom

The speculation has been driven by divergent Fed speak over recent days despite the disappointing economic reports. Most recently, Boston Fed President Eric Rosengren, another usually reliable dove, said the the central bank risks financial instability if it keeps rates anchored so low. San Francisco Fed President John Williams, a policy kindred spirit for Yellen, called for hiking "sooner rater than later."

With news that the Fed had teed up Brainard, who has been even more in favor of keeping rates where they are than Fed Chair Janet Yellen this year, market participants wondered whether the central bank was going to set up an unexpected rate hike at the Sept. 20-21 meeting.

"It certainly would be a clincher if she sounded any more hawkish," said Peter Boockvar, chief market analyst at the Lindsey Group. "I find it unusual that she would put together a speech just days before they go into a quiet period before the meeting."

Boockvar thinks September is a live meeting for the Fed and that a rate hike will reverberate.

"For a stock market that is wholly unprepared for that, not only could it get messy, it will get messy," he said. "The only reason why we're at these (stock market) levels is because of low interest rates and central bank policy. ... When the Fed removes accommodation, things are seen for what they really are, not for what people want them to be."

Wells Fargo economists said Friday that they believe the Fed will wait until December, but if it does go in September, then two hikes this year are likely.

The fed funds futures market is a finicky one, and attitudes were evolving through Friday trading, particularly after Fed Governor Daniel Tarullo made comments in a CNBC interview that were less than convincing that he favors a September move.

Read More From CNBC: Fed Governor Daniel Tarullo Wantd to See More Evidence of Inflation Before a Rate Hike

Consequently, the market-implied chance of a hike slipped back from 30 percent to 24 percent, or close to where it was before the Brainard news broke. Chances of a December move increased from about 52 percent Thursday to 57.4 percent Friday. Futures contracts indicate the funds rate will be at 0.41 percent by the end of this month, just one basis point higher than its current level, and 0.51 percent by the end of the year.

Prudential's Krosby believes Fed hawks are motivated less by economic data and inflation expectations than they "in fact are worried about financial stability, but for whatever reason they don't want to come out and scare the market."

"Most of the market believes the Fed lost their natural chance to raise rates," she said. "Market participants believe the Fed lost that chance and perhaps is now trying to make up for lost opportunity."