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Why Markets Aren't Worried About Bad GDP Report

The stock market is looking past the first contraction in the economy in more than three years, as traders focus instead on the promise of more dovish tones and easy policy from the Federal Reserve this afternoon.

Stock futures initially fell on the report of a contraction of 0.1 percent in fourth quarter gross domestic product, but when the market opened stocks recovered before dipping again.

(Read More: GDP Shows Surprise Drop in Fourth Quarter)

The last negative number was 0.3 percent decline in second quarter, 2009. Even the usually dour bond market continued to sell off after the report though yields were off their highs. The 10-year yield was still above 2.01 percent.

Focus shifted back to the Fed, which ends its two-day meeting with a statement at 2:15 p.m. ET. It is widely expected to maintain its easy stance on rates and continue quantitative easing programs to buy mortgage-backed securities and Treasurys. The promise of more Fed easing had earlier buoyed risk assets globally, ahead of the GDP report.

"The report, noisy as it is, may help ease ideas that has surfaced earlier this month that the Fed may look to soon pull back from its asset purchases," wrote Marc Chandler, chief currency strategist at Brown Brothers Harriman. The minutes of the last Fed meeting in December showed that some Fed members thought QE should end this year, a comment that helped send interest rates higher this month.

"Inflation, as measured by the core PCE in the GDP report showed a 0.9 percent increase, down slightly from Q3's 1 percent increase. If anything the whiff of deflation is evidence and this is keeping the Fed on track, buying $85 billion a month in long-term securities," Chandler added.

As for the stock market, it has moved close to its all-time high after a string of mixed data, some beating expectations and some missing. For instance, ADP private payroll data reported Wednesday showed 192,000 new jobs in January, well above estimates of 165,000.

(Read More: Private Sector Adds More Jobs)

"The stock market can continue to advance. What's propelling the stock market is fixed income markets that have reached their limit and low interest rates," said Steve Massocca of Wedbush Securities. "Despite the top line not looking all that good, these earnings reports, all these companies are beating on the bottom line so corporate profitability is is still pretty good. Interest rates are still basically zero and I think the stock market won't care unless the economy gets really bad."

Massocca said tepid data could actually be a plus for stocks since it will encourage the Fed to continue easing.

Some economists dismissed the GDP report as a once-off and expect to see it revised higher. "Nothing's changed. I think the economy is still growing at 2 to 2.5 percent," said Mark Zandi, chief economist at Moody's Economy.com. "I think a lot of things conspired in the fourth quarter," he said.

(Read More: Cramer Says GDP Decline Is a 'One-Off Number)

The surprise hit to GDP came from two volatile components. One was inventory accumulation and government defense spending. Barclays said these two elements subtracted 2.6 percent from overall growth. Economists had expected sluggish growth of 1 percent for the fourth quarter.

"The sharp drop in government defense outlays, -22.2 percent at an annual rate, may also reflect payback for strong growth in Q3 as well as a trimming of expenditures ahead of the scheduled sequester cut to the defense budget (originally slated for January)," Barclays economists wrote in a note. "The extent of further declines will depend on the outcome of the sequester debate but such sharp retrenchment is unlikely in our view."

Zandi said the inventory decline should auger well for future economic activity, as companies rebuild them. One hit to inventories was the decline in farm output, hit by the drought, he said.

Super storm Sandy also had some impact, hitting the northeast in late October, but that number was not quantified.

Zandi also said the pullback of military from Iraq and Afghanistan may be one factor affecting reduced defense outlays. He also attributed the defense drop to the possibility that cuts were being made ahead of the sequester, now expected to begin March 1.

The sequester is the automatic cuts to the budget that would take place, half of which hit defense spending, if Congress does not devise anew budget plan by then. The sequester was agreed as a compromise after the debt ceiling debate, and was intended to act as a stick forcing congressional action.

But Zandi said even if the sequester takes place, it will be a $65 billion hit to the economy, which will easily be able to weather it. Increasingly, traders have been speculating that Congress may be unable to agree on a solution for the sequester. "If they do that, we solve our fiscal crisis," for a while, he said.

But the sequester would hit on top of a 2 percent increase in payroll taxes that went into effect for all taxpayers this year, and the impact of that has yet to be felt. Some economists expect the tax increase to dent first quarter growth by as much as 1 percent.

There was also no sign of "fiscal cliff" impact in the numbers,a big focus of concern in the markets during the fourth quarter. "Business investment was up 8 percent and consumer spending was up over 2 percent. There's no discernible affect from fiscal cliff. This will be revised in a very big way," Zandi said, adding that final trade numbers haven't been factored in.

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

  • CNBC Personal Finance Correspondent

  • JeeYeon Park is a writer for CNBC.com. Follow her on Twitter: @JeeYeonParkCNBC

  • Rick Santelli joined CNBC Business News as an on-air editor in 1999, reporting live from the floor of the Chicago Board of Trade.

  • Senior Producer at CNBC's Breaking News Desk.