Stocks and government bonds are rallying from October 2022 lows, while the U.S. dollar continues to decline, upending expectations as Federal Reserve officials have repeatedly warned that relief from its aggressive rate surge could be a year or more away.

The S&P 500 rallied 11.6% from its Oct. 14, 2022, low to Jan. 13, recovering some of the losses from 2022's long sell-off. Government bond prices are also rising, pushing benchmark yields down from post-Great Recession highs, while the dollar has fallen from the record level set just months ago.

The market behavior reflects investors' views that with inflation likely past its peak, the Fed's battle to fight high prices with higher rates could be nearing its conclusion and a pause or even rate cuts could be on the horizon. The Fed, however, has warned just the opposite — rates are likely to rise further than the already imposed jump of 425 basis points since March, and Fed Chairman Jerome Powell has made clear a cut is not under consideration.

"The market is clearly playing chicken with the Fed right now," said Patrick Leary, a senior trader with Loop Capital Markets.

The S&P 500's recent rally is largely a reflection of optimism that a slowdown in inflation will pave the way for a more dovish Fed. The large-cap index fell 19.4% in 2022 as the Fed unleashed its most forceful monetary policy push since the early 1980s.

The dollar, which tends to rally as the Fed tightens monetary policy, has fallen roughly 6% from its mid-October high, according to the Dow Jones FXCM Dollar Index, which measures the dollar's value against the euro, the British pound, the Japanese yen and the Australian dollar.

Bond market sees cuts

Government bond yields, which fall as prices rise, have also reflected hopes of a less-hawkish Fed. The yield on the benchmark 10-year Treasury bond fell from 4.25% on Oct. 24, 2022, to 3.43% on Jan. 12.

"Bond markets seem to be convinced that the Fed will cut rates soon," said Callie Cox, a U.S. investment analyst at eToro.

But with the odds of a recession still high, the Fed has no argument to cut rates in the near term, Cox said. Though inflation is in decline and the Fed does not want to keep rates high forever, it is not going to deviate from its path as quickly as investors hope.

"I do think investors are getting the timing of rate cuts confused with the anticipation of rate cuts," Cox said.

Fears of misperception

Fed officials voiced concern over the recent easing of financial conditions in these markets during their December 2022 meeting, arguing that rallies in equity, bond and currency markets could undermine their efforts to bring inflation under control.

"Participants noted that, because monetary policy worked importantly through financial markets, an unwarranted easing in financial conditions, especially if driven by a misperception by the public of the committee's reaction function, would complicate the committee's effort to restore price stability," according to minutes from the meeting.

In short: If markets soar because investors believe the Fed's inflation mission has been accomplished, that mission will likely fail.

"The Fed can't risk its credibility with an early pivot while the market seems to be enthusiastically extrapolating a few data points to a trend," said Dec Mullarkey, managing director of investment strategy and asset allocation at SLC Management. "The Fed's reflex right now is to be cautious on cutting rates until they are certain inflation is well contained. Any missteps on relaxing too early would absolutely shred their credibility, ignite interest rate volatility and risk resetting inflation expectations higher."

The futures market expects the Fed to raise its target federal funds rate another 50 basis points to between 4.75% and 5% over the next two meetings, according to the CME FedWatch Tool, which measures investor sentiment in the Fed funds futures market. But a number of investors expect the Fed to also cut rates later this year. Roughly 20% of the market expected cuts to begin at the Fed's December 2023 meeting as of Jan. 17.

Labor market tightness

Leary with Loop Capital Markets believes that the Fed will likely slow its pace of hikes over the next two-to-three meetings of the rate-setting Federal Open Market Committee, but that largely depends on whether inflation can continue to cool toward the central bank's 2% target. The consumer price index, the market's preferred inflation measure, rose 6.5% year over year in December 2022, the U.S. Bureau of Labor Statistics reported Jan. 12. It was the sixth-consecutive month of lower annual growth since index readings peaked in June 2022 at 9.1%.

While the market believes inflation is moving in the right direction, the U.S. jobs market has remained significantly tight, with unemployment remaining at the lowest level in decades.

"While I do think inflation can and should come down here, if the Fed fails in slowing the labor market in a meaningful way, it will just pick up again, and they will be back hiking aggressively," Leary said. "By keeping rates higher for longer until the labor markets show signs of a real slowdown, the Fed can avoid this trap."

In addition, while the market has rallied on declining inflation and wage data, that could quickly change, said Steve Deppe, chief investment officer at Nerad + Deppe Wealth Management.

"I think the situation is very fluid at the moment, and while the market, collectively, does appear to be calling the Fed's bluff, we're only one hotter-than-expected CPI report from the market having to correct its expectations," Deppe said.