There are risks for markets and Yellen at Jackson Hole

The risk to markets Friday is that Fed Chair Janet Yellen simply sounds more ready than markets expect to raise rates for the second time in 10 years.That would trigger a sell-off in stocks, snap Treasury yields out of their slumber, pressure gold and pound on the dollar. But many strategists and economists say more likely is that she will sound dovish, and the reason may be that she will choose to address a more wonky academic question about long-term Fed policy rather than talk about what the markets want to hear. At the same time, the Fed's mixed messages, internal conflicts and pondering of longer-term issues have confused markets, and if she doesn't sound more confident on the economy, that may also create a backlash in the markets. The has said it could raise rates twice this year, but the market barely expects one hike, at its December meeting.

"She's going to say what they've said before. I think the Fed's on track to hike this year, no real message on exactly when. Definitely, the market will be looking for things. I can't imagine her specifying a meeting, so she's going to give a boiler plate Fed statement. The more interesting thing will be the discussion on the sidelines among other members. Does the FOMC sound hawkish or not? Right now, you look at the Fed and there's a huge range of views there. They're grappling with the question of how well the economy can handle hikes and do they really want to hold the 2 percent [inflation] target now," said Ethan Harris, Bank of America Merrill Lynch co-head of global economics research.

The speech at Jackson Hole is perhaps one of the more widely anticipated chairman speeches outside of the financial crisis for the Kansas City Fed's annual symposium. It comes at a difficult time for the central bank, a time when market participants question the credibility of the Fed and doubt that global central bankers have any more fire power to fix the global economy. It's also a tricky time for the Fed, which could also easily find itself a political football during a contentious election year. The topic of the conference is "Designing resilient monetary policy frameworks for the future" and Yellen's specific topic is, "The Federal Reserve's monetary policy toolkit." The Fed chair is expected to walk carefully between a dialogue about the Fed's policy tools and the current economic environment without tilting toward any current policy discussion. Yellen's speech will not be televised, nor is she expected to take questions following it.

If Yellen surprises the market in a hawkish way, strategists say the 10-year could break out of that range quickly, and the two-year yield would also rise. "I do think Jackson Hole is a possibility. My general conclusion is that the market is fairly complacent for a good reason. The Fed has been remarkably inactive and has been very quick to become cautious at any whiff of worry," said Gene Tannuzzo, senior fixed-income portfolio manager at Columbia Threadneedle Investments. Tannuzzo does not expect much from Yellen, but if she suggests an interest rate hike could be coming soon, then the market could react. Last week, New York Fed President William Dudley told reporters that it could be appropriate for the Fed to hike rates soon, including in September, while Fed Vice Chair Stanley Fischer said the Fed's objectives are close to being met.

"I don't really think there's any huge policy announcement coming at Jackson Hole, but if Yellen does start to take the side of recent commentators like Bill Dudley and Stan Fischer and says, 'The economy doesn't look that bad, and I think we could squeeze in an interest rate hike,' then I think the market could get pretty spooked," said Tannuzzo. Based on action in futures markets, traders have placed odds at just above 50/50 for a December rate hike, while the odds of a hike at the September meeting have risen to about 30 percent from around 20 percent last week. "The media has been trying to spin how all these Fed speakers are trying to talk up the chances of a rate hike, so we've gotten up to a 55 percent chance of a rate hike by December," said John Briggs, head of rate strategy at RBS.

Harris said by bringing up that discussion at Jackson Hole, the concept may not be understood. "That whole debate about 2 percent is making the Fed less clear. The people in the market are already confused about what the Fed's going to do. This is just adding a new layer of confusion into the market. Tell us what they're doing. She needs to talk more. I don't think this is the right vehicle. They need to start the discussion at the FOMC meeting," he said. Critics of the higher inflation target suggest it would just extend easy policies that have not been able to give much lift to the economy.

"A new inflation target would undermine the Fed's commitment to any policy framework. It would please the denizens of Wall Street who pine for still-looser Fed policy. And households would be understandably miffed to receive a new lecture on unconventional monetary policy—this one on the benefits of higher prices," wrote former Fed board member Kevin Warsh in The Wall Street Journal. "A change in inflation targets would also add to the growing list of excuses that rationalize the economic malaise: the persistent headwinds from the crisis of the prior decade, the high-sounding slogan of 'secular stagnation,' and the convenient recent alibi of Brexit."

The Fed is swimming upstream against a flood of central banks cutting rates and extending asset purchases with now an estimated $13 trillion in negative yielding bonds thanks to central bank policies in Europe and Japan. But some market participants believe, as a result, the Fed will have a hard time taking the next steps toward normalizing policy because of that.

"The Fed wants to have it both ways. They want lower rates because they know that helps the economy. At this point, however, what they are really worried about is no inflation as much as that they are lowering volatility, leading to asset prices at a much higher level and causing all sorts of financial stability–related concerns. If the financial markets were at a 20 percent discount, I don't think they'd be as worried as they are," said Memani.

Besides the Fed, there is some data ahead of the market open. At 8:30 a.m., revisions to second-quarter GDP will be released. At 10 a.m., there is consumer sentiment.