Market's message to the Fed: We don't believe you

The market still believes the Fed is overstating how many times it will raise rates this year.

Even with the forecasts the U.S. central bank released this week that were even more dovish than before, traders anticipate no more than one hike in 2016, according to fed fund futures activity Thursday.

The Federal Open Market Committee on Wednesday declined to rate its interest rate target, with members also cutting back the future trajectory from the four hikes predicted in December to two. The forecast, included on the so-called dot plot in the Summary of Economic Projections, brought the Fed closer to the market, but not quite all the way in a continuing conflict that some say has contributed to market instability.

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"The 'dot plot' ... is much better anchored to market realities than the March 2015 version," Nick Colas, chief market strategist at Convergex, said in a note to clients. "At the same time, fed funds futures markets are still skeptical that the Fed has it right."

There's a 52 percent chance of a rate hike in July, according to the CME's FedWatch tool. While that's far from a lock, it is the first month ahead with a better-than-even chance. The September meeting, after which Chair Janet Yellen hosts her quarterly news conference, is a stronger bet, with a 60 percent chance.

A specialist works at the New York Stock Exchange on March 16, 2016, as the decision of the Federal Reserve appears on a TV screen.
Richard Drew | AP
A specialist works at the New York Stock Exchange on March 16, 2016, as the decision of the Federal Reserve appears on a TV screen.

However, the market is pricing in very little probability of another move. A second hike in December now has just a 33 percent chance.

Looking at the actual futures contracts, the curve has steepened. Traders now aren't pricing in a full rate hike, or a near-100 percent chance, until January 2017.

Jim DeMasi, chief fixed income strategist at Stifel Fixed Income, as among those who see just one hike from the Fed this year.

"The Fed is in no hurry to raise short-term interest rates and does not intend to follow a calendar-based approach to tightening policy. The decision to raise rates in December was based on 6.5 years of cumulative progress toward the Fed's dual mandate (rather than one or two quarter's worth of economic data) and was not intended to signal the beginning of a time-based sequence of additional rate hikes," Demasi said in a note.

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"Simply put, the Fed plans to follow the advice of the recently departed Glenn Frey (the Eagles musician) and 'take it easy' while traveling down the road toward policy normalization," he said.

To be sure, the funds market is volatile and can turn rapidly.

In fact, Goldman Sachs economists believe there will be three rate hikes this year, making both the Fed and futures traders wrong.

"We disagree somewhat with the FOMC's outlook for the economy — particularly their read on the incoming inflation data — and at this point see no reason to change our views," Goldman economists Jan Hatzius and Zach Pandl said. "Despite today's dovish surprise, we have not changed our baseline forecast that the committee will hike three times this year, at the June, September and December FOMC meetings."

The Goldman team did add that risks to their forecast "tilt to the downside," meaning fewer rate hikes are possible if inflation fails to gain steam.

There's certainly some reason to believe the Fed is underestimating the pace of inflation. The Atlanta Fed's measure of core "sticky CPI," or the consumer price index components that are slow to change, is just above 2.5 percent, considerably ahead of the FOMC's 2 percent target. However, the committee more closely adheres to the personal consumption expenditures index, which is 1.7 percent, excluding food and energy.

As such, the Fed indicated this week that it will take an even more measured approach to policy tightening than Wall Street had anticipated. Even though there was one dissenter at the meeting — Esther George of Kansas City — Convergex's Colas pointed out that the dots on the dot plot are far more clustered than they were a year ago, indicating close consensus about the direction of policy.

While markets have been in a risk-on rally mode since the decision, not everyone is happy.

"It is safe to say that after yesterday's FOMC statement, the Yellen press conference and what was said in them, the communication and structural strategy of 'data dependency' has been officially neutered," Peter Boockvar, chief market analyst at The Lindsey Group, said in a note. "The Fed's goal is now a perfect world. As we of course will never get there, the rest of us are left flying blind as to what to expect from monetary policy."