New Federal Reserve Chairman Jerome Powell just started his new job but Wall Street already is skeptical of his ability to raise rates.
The market has priced in 2.9 rate hikes for this year, but "remains skeptical" about what might come after 2018. Investors have priced in 1.7 hikes during this rate hike cycle, BofA Merrill Lynch analysts wrote.
The Fed, however, has signaled seven hikes through 2020. Analysts said, "We think that the market is mispriced and will ultimately capitulate to the Fed, sending rates higher."
There are three triggers that will get Wall Street to price in more hikes beyond this year: signs of cyclical inflation, growth momentum beyond 2018 and expectation of higher equilibrium rates.
"Our core 2018 rates views are that improved growth through easier fiscal policy, higher deficits, greater Treasury supply and building inflation expectations should result in a further increase in rates and steepen intermediated dated Treasury curves," BofA wrote. "Improvements in the outlook could cause the market to reassess the Fed's terminal rate or the length of this business cycle."
The narrative matters for the stock market, analysts noted. "The worst case for stocks is the first factor where inflation accelerates, indicating a tighter labor market and forces the Fed to hike faster in order to quell inflation," BofA said.
According to analysts, "a more aggressive central bank in the face of higher inflation does not bode well for stocks."
A more bullish case would be a higher estimate of equilibrium rates, implying a longer business cycle and a "capacity for the economy to continue to expand, handling higher rates."
The market currently prices in a terminal rate of 2.5% for this hiking cycle, about 40 basis points above the mid-December reading before the passage of tax reform. While tax legislation lifted the terminal rate estimate some, it "remains relatively low on a historical basis," BofA said. "In order to meaningfully shift this measure of the terminal rate higher, the market will likely want to see [signs of cyclical inflation, growth momentum beyond 2018 and expectation of higher equilibrium rates.]"
"Historically, the market appears to lead the Fed in terms of adjustments to terminal rate expectations, potentially signaling an upward revision is likely in an upcoming Fed meeting," BofA said. "Any shift from the Fed to raise their longer-run median expectation could be interpreted positively by the market and might be a vote of confidence that the economy's longer run prospects would be improving."