Market Volatility Likely with Focus on Fed and Iraq
Business + Economy

Market Volatility Likely with Focus on Fed and Iraq


Market volatility is likely to pick up in the week ahead, as focus shifts to the Fed and the possibility it could start to hike interest rates a bit sooner than expected.

But the unfolding situation in Iraq will also dominate market talk, particularly if it continues to push oil prices higher.

The success of Sunni militants in seizing key cities in Iraq emerged as a fresh geopolitical headwind in the past week and helped send stocks to their first losing week in four weeks. The S&P 500 fell 0.7 percent, to 1,936, and the Dow fell 0.9 percent, to 16,775.

Related: The Need for U.S. Special Forces in Iraq

Oil, meanwhile, had its best week since December as concerns mounted that the second-largest OPEC producer could see supply disruptions. Brent futures rose 4 percent, to $113.41 per barrel, and West Texas Intermediate rose along with it, finishing Friday at $106.91, the highest level since September.

"I would agree this latest flare up in Iraq and other tensions aren't enough to cause a market correction of even five percent," said Deutsche Bank chief U.S. equity strategist David Bianco. "It's something to pay attention to. I wouldn't ignore it, but it doesn't change my calculations as they otherwise stand, which really is a larger concern on interest rate risk…I still think the main issue for the market is can 10-year Treasury yields stay low as job gains pick up?"

The Federal Open Market Committee meets Tuesday and Wednesday and is expected to cut its growth forecast for 2014, given the negative 1 percent first quarter GDP. Its forecast was for 2014 GDP of 2.8 to 3 percent. The Fed is also seen paring back its expectation for unemployment, which leads to speculation that members could pull forward their expectations for hiking short-term rates.

"We expect that next week's FOMC meeting will produce an economic forecast that shows the Fed getting closer to their mandate, which could result in somewhat higher interest rate forecast (the dots) for 2015 and 2016, but that the FOMC statement will reaffirm that a highly accommodative policy remains appropriate," wrote Michael Feroli, chief U.S. economist at J.P. Morgan.

Related: Iraq Unrest Drives Concerns About Oil Spike

Feroli and other economists expect the Fed to adjust its expectations of an unemployment rate of 6.1 percent to 6.3 percent by the fourth quarter because unemployment has already moved down to 6.3 percent. "We think the lower end of the unemployment central tendency in 2014 will have a five-handle," Feroli noted. Fed officials' individual forecasts for the Fed funds rates are represented on a graph with dots under the dates where members see rates moving.

Deutsche Bank economists point out that as of March, the median forecast for the fed funds rate was 1 percent by year-end 2015 and 2.25 percent for 2016, but that is likely to change. "The financial markets are likely to once again focus acutely on any perceived shift in either the liftoff date or pace of tightening," they noted. But the Fed could also temper this change by noting it could keep rates low for a long time.

Bianco said the Fed could bring forward its first rate hike to early 2015, from the consensus mid to late 2015.

"I think it's fair to say that we expect the Fed to say the same thing, to acknowledge the data has improved at least for the second quarter," he said. "The Fed will acknowledge that but they'll also stay the course on policy, particularly when it comes to guidance on the Fed funds rate."

Related: Economists Predict Worker Pay Increases 

The Fed is also expected to trim back its bond buying program by another $10 billion. Fed Chair Janet Yellen also holds a presser and that could also bring volatility. Although the Fed could ruffle markets temporarily as investors focus on its projections, the impact of what's going on in Iraq is not clear.

"This week's headlines gave the market an excuse to pull back and work off its overbought condition," said Scott Redler, of "Now we're heading into next week with the Fed on Wednesday, and traders are going to try to figure out whether the pullback just happened or whether it goes a little deeper."

James Paulsen, chief investment strategist at Wells Capital Management agrees with Bianco that unless there is greater escalation, the situation in Iraq should not have a big impact on the stock market, and for now he does not expect a big oil spike. He said it's possible the S&P 500 could take out the 2,000 level before reversing course. His target is 1,850 for year, however, so he expects the market to give back its gains.

Paulsen said he doesn't like energy stocks, the best performers of the week because they are overvalued. "Iraq is hugely important but I don't' think it's going to be a big market issue. I don't' think there's going to be enough disruption created by the turmoil," he said. "The U.S. is in a much better position oil wise than it's been."

Bianco said he thinks oil prices are too high, based on growth in demand as emerging markets grow more slowly. "If we're right that the U.S. is going to see higher interest rates, we think we'll have a stronger dollar. Those things are usually additional pressures on commodity prices. I'm underweight energy (stocks) on the view that we're getting the last hoorah of the oil price rally," he said. But he also expects oil stocks could be the beneficiaries of Iraq headline risk.

"Right now, it's just more good stuff for the energy sector. I don't think anybody's in a panic yet for what this means for prices at the pump. I would guess you'd need Brent above $125 before this could be a problem and slow the pace of consumption," he said.

What to Watch

8:30 a.m.: Empire State survey
9:00 a.m.: TIC data
9:15 a.m.: Industrial production
10:00 a.m.: NAHB survey

FOMC meeting begins
8:30 a.m.: CPI
8:30 a.m.: Housing starts
8:30 a.m.: Building permits

Earnings: FedEx
7:00 a.m.: Mortgage applications
8:30 a.m.: Current account Q1
2:00 p.m.: FOMC statement and projections
2:30 p.m. Fed Chair Janet Yellen press briefing

Earnings: OracleBlackberry
8:30 a.m.: Initial claims
10:00 a.m.: Philadelphia Fed survey
10:00 a.m.: Leading indicators

Earnings: Darden Restaurants

This article originally appeared in CNBC.

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