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Investors are getting the Fed—and the economy—all wrong

Federal Reserve Chair Janet Yellen
Chip Somodevilla | Getty Images
Federal Reserve Chair Janet Yellen

The Federal Reserve is set to release its next policy statement on Wednesday — and investors who expect to hear hawkish talk from the central bank may be in for a surprise.

Since Emmanuel Macron's strong showing in the first round of the French presidential election, capital markets have been on a risk-on tear, with U.S. 10-year Treasury yields rising nearly 20 basis points off their lows, fed funds futures pricing in a greater than 75 percent chance of a rate hike in June and the U.S. dollar/Japanese yen up sharply from its 2017 lows.

The problem is that the underlying economic picture has not changed. If anything, U.S. data appear to have deteriorated, with Citibank's economic surprise index now in negative territory. Even Monday's economic reports were lackluster at best, with personal income growing at a paltry 0.2 percent in March, while consumer spending printed a big doughnut at 0 percent growth on the month. The much-vaunted pickup in consumer spending is nowhere to be seen.

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Worse, the Fed's favorite measure of inflation, the personal consumption expenditures (or PCE) index came in at just 1.6 percent on a year-over-year basis — well below the 2 percent target that the central bank is seeking.

Overall, the most recent data of out the U.S. is confirming the stance of Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, who has been a renegade on the FOMC by voting "no" to rate hikes at the prior meeting in March. As he told CNBC, "For the last five or six years, the Federal Reserve keeps predicting inflation is around the corner. And those predictions end up being wrong."

Indeed, the Fed's recent turn toward hawkishness appears to have less to do with basic economic fundamentals and more to do with its desire to re-establish control over monetary policy and return to "normalization" as soon as possible. In short, the main reason the Fed wants to hike rates now is not because the U.S. economy requires it, but so that it can have the flexibility to lower them again during the next economic slowdown.

Yet such a policy path is fraught with risk. While the U.S. economy appears to be on steady footing now, any additional tightening could suppress consumer spending even more, and given the lack of any obvious immediate catalysts to spur growth, it's difficult to see how the Fed will remain so unabashedly hawkish going into the June meeting.

This week will provide policymakers with a slew of data including both employment and wage growth numbers at the end of the week. But unless they are markedly better than forecast, the FOMC may choose to hold off on any tightening action until September.

My prediction? When that becomes obvious to the markets, much of the recent movements in capital markets will be unwound, with 10-year yields dropping back below 2.2 percent and the dollar/yen drifting toward the important 110 level.

Equity investors, meanwhile, might think that a more dovish Fed would be good for stocks. But I think the stock rally will stall as investors begin to ask: Where is the growth going to come from?

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Brian Sullivan

Brian Sullivan is co-anchor of CNBC's "Power Lunch" (M-F,1PM-3PM ET), one of the network's longest running programs, as well as the host of the daily investing program "Trading Nation." He is also a frequent guest on MSNBC's "Morning Joe" and other NBC properties.

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