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Right here's why the market could also be incorrect concerning the Federal Reserve and rates of interest

Traders on the floor of the New York Stock Exchange.

Source: NYSE

Monday's aggressive stock market rally came despite fears by a Wall Street company that investors still fail to see how quickly the Federal Reserve could begin raising rates.

After being hammered for the past three days of trading last week, Wall Street came back with a move that propelled the Dow Jones Industrial Average up more than 1.5%.

"The market is returning to its comfortable mode," Mohamed El-Erian, Allianz's chief economic advisor, told CNBC's "Squawk Box". "The growth is strong. They still believe that inflation is temporary. You believe the Fed will be relatively slow in tapering [monthly stock purchases], and that's why you see" stocks higher.

This optimistic view of Fed policy is a mistake, according to Bank of America loan strategist Hans Mikkelsen.

The Fed's Open Market Committee meeting last week ended with officials pointing out they expected two rate hikes as early as 2023, faster than the market had expected.

However, Mikkelsen believes that monetary tightening could come even sooner.

"Expect the Fed to start tapering its [quantitative easing] purchases soon and raise interest rates earlier than expected – and most importantly, much faster than the current market prices," he said in a statement to clients.

The bank's analysis found that the committee only "two points", or the projections of two members of the 18-person committee, kept from implementing the first rate hike by 2022. The panel split evenly on whether to change interest rates over the next year, while eight members saw up to three hikes for 2023.

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Taken together, members' opinion of where policy should go was a marked departure from a historically simple Fed.

Mikkelsen said the credit market, which has slashed interest rates despite the restrictive Fed, is misjudging the direction of the central bank. From a market perspective, there is only a 41% chance the Fed will raise rates by July 2022, according to the CME's FedWatch tracker.

"The most important mispricing in the interest rate market, as our interest rate strategists emphasize again and again, is not the rate hike, not the time of the first rate hike, but the pace of interest rate hikes from this point on, which is much too flat compared to the normal situation. , he wrote.

Mikkelsen pointed out that the Fed has already begun easing the throttling with its actions to liquidate the small portfolio of corporate bonds it bought during the Covid-19 pandemic. This move, "which was 100% unexpected given the Fed's poor track record of selling assets – was a signal that the Fed is becoming increasingly encouraged to abandon its super-easy monetary stance, even if it means market expectations to defy. "

Changes to the Fed

For their part, Fed officials point out that the landscape is indeed changing, as reflected in dot-plot projections released Wednesday.

New York Fed President John Williams reflected the consensus view in a speech on Monday when he said he saw inflation as temporary and Fed policies appropriate given current and expected conditions.

"It is clear that the economy is improving rapidly and the medium-term outlook is very good. But the dates and conditions are not advanced enough for the FOMC to change its monetary policy stance to strongly support the economic recovery." said Williams in prepared remarks.

But opinions differ within the Fed.

St. Louis Fed President James Bullard rocked the market on Friday when he told CNBC he was one of the FOMC members who think a rate hike in 2022 is appropriate. Bullard is not a voter this year but will be next year.

But Robert Kaplan, president of the Dallas Fed, said Monday he was focusing more on slowing the pace of bond purchases – tapering – and saw the interest rate question as a question that needs to be answered another day.

"I would prefer that we act sooner rather than later on asset purchases, then we will make a decision about the additional steps that are required in 2022 and beyond," said Kaplan, who was presented for discussion with Bullard from the Official Currency and Financial Institutions Forum. "But I think the issue that is on the table today and in the near future is timing and adjustment of those purchases."

Both officials noted the progress of the economy and see the reason why the inflation that has emerged over the past few months may be a little stickier than the Fed expected.

"The imbalances between supply and demand, some of which we believe will resolve in the next six to twelve months," Kaplan said. "But again, we believe some of them are likely to be more persistent, driven by a number of structural changes in the economy."

For example, he cited changes in the energy industry – a key component of Kaplan's district – towards sustainable energy as contributing to prolonged inflationary pressures.

Bullard spoke of the development of the labor market as an important aspect of future Fed policy.

"We need to be prepared for the idea that there are upside risks to inflation," he said. "Certainly the anecdotal evidence is overwhelming that this is a very tight job market."

If these inflationary pressures are bigger than Fed officials think, it will force them to tighten policies faster than they'd like. That would hit the stock market and the economy at large, both of which are dependent on lower interest rates.

A tight Fed would drive up borrowing costs for a government that was on a spending frenzy last year and wants to do even more with infrastructure.

"Right now, inflation is temporary. But if you layer that with significant additional stimulus, you run the risk of making something ephemeral permanent," said Joe LaVorgna, Natixis chief economist for America. "So you are in a really difficult position. I think the Fed's best approach is to say less."

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