Stocks and bonds duked it out over how to interpret the Fed's latest minutes, and it seems the bond market is winning.
The Federal Reserve signaled in its latest meeting minutes that it will continue to raise rates, but stocks initially rallied on a seeming silver lining in that the Fed does not appear overly worried about inflation.
That would mean the central bank would continue on a gradual course, not speeding its hiking cycle much, as the market has been fearing.
But in the bond market, yields rose to the highs of the day, with the 10-year yield hitting a fresh four-year high, as traders there focused on the Fed's comment that it expects "further" policy firming, or further rate hikes.
But as stocks initially surged after the 2 p.m. ET release of the minutes, taking the Dow Jones industrial average 300 points higher, bonds sold off more. Rates move opposite price. The Dow then pulled a total reversal, erasing all of its gains and closing down 166 points at 24,797.
"I think they first grabbed at all the dovish stuff, and then they said 'wait a minute,'" said Art Cashin, UBS director of floor operations at the New York Stock Exchange. "I think it's simply a rethink and now it's feeding on itself."
The bond market was fixated on the fact the Fed said the stronger economic growth raises the likelihood that "further gradual policy firming would be appropriate." That would suggest rate hikes are on the way, and possibly even more than the three the Fed has forecast. The central bank also said it added the word "further" to its post-meeting statement Jan. 31 to reflect the improved economy.
The Fed also said there are upside risks to growth from the tax cuts, and a number of officials raised their growth forecasts since the December meeting. On inflation, the Fed said members didn't see signs of broad-based wage growth as of their meeting.
"I think what [soothed] the market is it's hiking for the right reason because economic growth is better, not because inflation is moving at a breakneck pace, at least according to the Fed," said Michael Arone, chief investment strategist at State Street Global Advisors. "That's the best kind of environment for stocks. The reason rates are rising is because the economy is doing better."
The Fed said almost all of its officials expected inflation to rise to their target 2 percent level. The markets were braced for a more hawkish sounding Fed, particularly on inflation.
Treasury yields had initially stalled but then rose with the 10-year at 2.95 percent, and the 30-year at its high of the day at 3.22 percent. The two-year, which is most sensitive to the Fed, slipped slightly to 2.25 percent.
"I think this shows there's still an active debate around inflation. ... It doesn't seem anyone at this point is worried about an abrupt move up in inflation or an inflation scare," said Michelle Meyer, head of U.S. economics at Bank of America Merrill Lynch.
Amherst Pierpont's chief economist, Stephen Stanley, said while there's nothing new, the market still does not have a sense of Fed Chair Jerome Powell, who took over from Janet Yellen right after the last meeting.
"We certainly do know that the final Yellen-led meeting has far less relevance to the future behavior of the Fed than the usual meeting might. Second, a lot has transpired since January 31. Financial markets went crazy for a few weeks, while the wage and core inflation readings released this month have been upside outliers, substantively changing the landscape vs. what it looked like on January 31 (and potentially making a good bit of what was communicated in the January minutes look really stupid in a few months)," Stanley wrote.
Meyer expects to see the three rate hikes the Fed has forecast for this year. But other economists expect the Fed to add another, with the first in March.
"I don't think it changes the timing for rate hikes. They clarified why they put the word 'further' in. It makes sense. Risks have become a bit more favorable, but they didn't suggest they would deliver hikes that are faster or shift to an accelerated hiking cycle," Meyer said. "They are committed to this gradual trajectory of rate hikes."
Ward McCarthy, chief financial economist at Jefferies, said the minutes really revealed nothing new despite the market action.
"There's not much to think about here. ... They seem to be more optimistic about the economy, a little bit less confused about inflation, but there's not profound change here between December and January. You wouldn't expect to see it as it was Janet Yellen's last meeting," he said, adding there will be more information on how many rate hikes this year when the Fed releases its forecasts after its meeting March 21.