Markets don't believe the Fed when it comes to where rates are headed

Published Wed, Jan 11 202312:29 PM ESTUpdated Thu, Jan 12 20238:08 AM EST

No matter how many times Federal Reserve officials say they're raising interest rates and keeping them there, the markets don't want to believe them. A fresh round of seemingly hawkish comments from central bankers this week did little to dent the outlook from traders. In fact, if anything the market moved to a more dovish position, pricing in a near certainty of another step down in the level of rate hikes when the Fed convenes again at the end of January. "Markets are roundly and decisively ignoring the Fed's rate guidance, less than 1 month after they published it," DataTrek Research co-founder Nicholas Colas wrote in his daily market note Tuesday evening, referring to projections from the Fed's Dec. 13-14 meeting. "Whether that proves right or wrong is not yet really the issue," he added. "More important is how much the Fed wants to correct the market's dovish stance. Recent comments from Fed presidents have tried, and failed, to nudge the market's view towards the [Federal Open Market Committee's] guidance." Traders are pricing in nearly an 80% probability that the FOMC approves a 0.25 percentage point rate increase when it releases its post-meeting decision Feb. 1, according to CME Group data . That's about double the probability of a month ago, just before the committee made a 0.5 percentage point move that took its benchmark rate to a target range of 4.25%-4.5%. Along with the hike, committee members raised their view on where they think the fed funds rate is headed long term — to 5.1%, with no cuts at least through 2023. Doubts about the 'terminal rate' Markets, though, aren't buying it. In addition to the expectation for a smaller cut at the upcoming meeting, fed funds futures contracts are pointing to a "terminal rate" of 4.94% by mid-summer. The futures market also is indicating the likelihood of cuts of as much as half a percentage point by year-end. Treasury yields also have been falling in early 2023. The 2-year note , which is the government fixed income instrument most susceptible to monetary-policy changes, has seen its yield fall considerably over the past week, down about 20 basis points — 0.2 percentage point — since the minutes were released a week ago from the FOMC's December meeting. That pricing comes despite statements this week from Fed Chair Jerome Powell as well as regional presidents Raphael Bostic of Atlanta and Mary Daly of San Francisco indicating a still aggressive path ahead at least until inflation shows consistent signs of being subdued. Powell, for instance, stressed the Fed's need for political independence while it makes choices that could be unpopular. Daly said she remains open to a half-point hike at the upcoming meeting. And Bostic said his philosophy on how long the funds rate would would stay above 5% could be summed up in "three words: a long time." So, why the disparity? Hope for inflation The best explanation is that the market thinks inflation will come down sooner than the central bank does. Consequently, it sees less need for higher rates. "Unless something breaks that induces tremendous contagion, the Fed is going to deliver price stability. That's the mandate, and that's [Powell's] legacy," said Quincy Krosby, chief global strategist for LPL Financial. "What the market's suggesting is that he may be delivering price stability sooner rather than later." Markets will learn more about where inflation is heading on Thursday when the Labor Department releases its consumer price index at 8:30 a.m. ET. The Dow Jones estimate is for a 0.1% monthly decline for headline CPI and a 0.3% gain for core. If those estimates are accurate, they would provide the most convincing signal yet that inflation, while still well above the Fed's 2% target on an annual basis, is retreating. Another few months of similar data could bring the Fed closer to the market's side — and deliver a much-needed win for Powell after he guided the central bank through a lengthy period of denial about how sticky inflation was going to be. "This is Powell's legacy," Krosby said. "If he can deliver price stability coupled with a softish landing, he would be well regarded in the pantheon of central bankers who have had to deal with inflation."