After 10 months and 425 basis points of rate hikes, the Federal Reserve is in a showdown with financial markets over just how much monetary policy tightening remains.

On Feb. 1, the Fed is expected to announce a 25-basis-point increase to its benchmark federal funds rate, the smallest hike since March when the central bank began its battle against skyrocketing inflation after two years of near-zero rates. Key Fed officials have indicated that this week's rise could be followed by another one or two 25-basis-point hikes over the spring, then the cycle will be paused and rates will remain high into 2024.

Recent rallies in stocks and bonds, meanwhile, show that financial markets are betting that the Fed's hawkish policy push is nearing its end and rate cuts could happen later this year, even as Fed Chair Jerome Powell will likely repeat his belief this week that the fight against inflation is still far from over. The disconnect between investors' views and the central bank's ultimate path could throw markets back into turmoil or potentially force the Fed to redraw its course if inflation spikes again amid easier financial conditions.

"There's a stare-down going on right now," said Ken Matheny, executive director for U.S. economics at S&P Global Market Intelligence. "Are financial markets going to say: 'Oh boy, the Fed was right, we goofed,' and then bond yields need to spike, or at least reverse some of their recent declines. Or is the Fed going to say 'Darn it, the bond markets are right, we can start cutting rates by September of 2023,'? Who's going to blink first?"

Bond yields, which vary inversely with prices, surged throughout much of 2022 as the Fed pushed up rates. They began to dip late in the year as inflation and wage growth began to show signs of cooling, bolstering a growing market view that the Fed could turn dovish earlier than expected.

This view has also pushed up stocks and ended a historic dollar rally, causing the greenback to lose ground to its Group of 10 peers this year.

Fed continues fight

During his press conference this week, Powell will likely try to tame some of the market's enthusiasm by stressing that inflation remains above target, the Fed does not plan to reverse the course of policy anytime soon, and it will push back against any suggestion that a rate cut is even under consideration, Matheny said.

"He's going to reiterate that the Fed is adamant, that it is determined … and just a handful of encouraging inflation reports are far from sufficient to conclude that it's time to abandon the fight," Matheny said.

As of late last week, the futures market was betting that the federal funds rate would top out at a range of 4.75% to 5% this summer, 50 bps above where it is currently, according to the CME FedWatch Tool, which measures investor sentiment in the Fed funds futures market.

Nearly 50% of the market sees the Fed cutting rates by December, according to the tool.

"The biggest disconnect between the Fed and the market right now is not how high the terminal rate will get, but how long it will stay there," said Jason England, global bonds portfolio manager at Janus Henderson Investors. "No matter how many times Chair Powell and other Fed members stress they need to stay higher for longer, the market does not seem to believe them."

Powell this week will likely press the idea that the central bank will be maintaining these rates, the highest since 2007, throughout this year.

"Even though the economy is slowing, that will not be enough for the Fed to pivot to cutting rates this year unless they start to see job losses that does more than just soften the labor market," England said.

Powell will likely continue to push a hawkish message this week, said Kathy Jones, managing director and chief fixed-income strategist with the Schwab Center for Financial Research.

At the same time, he will acknowledge that the full effects of rate hikes on the broader economy have yet to take root, potentially opening the door to a policy shift later this year, Jones said.

"It's going to be a balancing act, but the weight is likely to still be on the hawkish messaging," Jones said.