At first glance, today's movement in bond markets along with the buoyancy of equities looks like one of those instances where an indicator that the Fed keys off of is enough of a negative surprise that the positive trigger of monetary offset overwhelms the negative information. This would not be the case if the Fed wasn't persistently positioned outside the range of optimal policy. It is only the case because monetary policy is tight enough that loosening will benefit the real economy.
In any case, on closer inspection, I don't think the bond markets did react today with an expectation of a delayed rate hike. In my Eurodollar futures indicator, the expected date of liftoff didn't change a single day today. It was January 2 at the beginning of the day and it was still January 2 at the end of the day. What changed was an increase of uncertainty about the date of the first hike and a sharp decline in the expected rate of hikes once they begin. This is now all the way down to only 50 basis points per year. That is very flat. I don't think the yield curve has been this flat since the crisis. It's a new low.
I think this is more evidence that the current natural rate is not appreciably above zero, and any rate hike is expected to reverse fairly quickly.
But, why would equities rise? My best guess is that the lack of wage gains gives hope that the downward pressure we have seen on profits over the past couple of years will lighten up. I'm not completely satisfied with that answer. This is not the only indicator that is beginning to show early signs of potential cyclical peaks in equity and labor markets, so if bond markets don't expect a Fed reaction here, I would think that recession fears would dominate.
On the other hand, far forward rates only fell a few basis points today and have held fairly steady, albeit low, for most of the year. So, maybe markets expect the Fed to stick to its current plan for the first rate hike and then to be extremely careful about doing anything else after that. Is it possible that we can thread the needle and continue down a path of very low inflation without triggering a liquidity problem? Or, is the buoyancy of the far forward rates due to the asymmetrical effect of uncertainty at the zero lower bound, and what we are seeing is something close to a flat yield curve with ZLB distortions?