Bond market stares down the Fed

Fed officials keep saying they want to raise interest rates this summer, but somehow the bond market doesn't quite believe it.

Markets were fairly quiet Monday with the stock market closing lower on light volume. The S&P 500 (INDEX: .SPX) slipped four points to 2,048, and the Dow (Dow Jones Global Indexes: .DJI) was down eight at 17,492. Treasury yields, at the short end, were slightly higher with the two-year (U.S.: US2Y) around 0.89 percent in late trading. The 10-year (U.S.: US10Y) yield was about 1.83 percent.

"I don't think the market is prepared for June yet," said Brian Rehling, co-head of fixed income strategy at Wells Fargo Investment Institute. "The more dovish [FOMC] members, obviously Janet Yellen, is part of that. … They appear to hold the majority of the committee, and I think they're going to wait for more economic data to really prove out that they should raise. There are some risks if they raise too early."

The markets are awaiting a few data points this week, but they are mostly anticipating some words from Fed Chair Janet Yellen , who will receive an award at Harvard on Friday. While Fed watchers had expected little new information from this appearance, expectations have ramped up in the markets and some trading could be subdued ahead of it. She will also be interviewed on her achievements by economist Greg Mankiw, where traders are hoping to hear some policy insight.

DoubleLine CEO Jeff Gundlach says it's the Fed Chair's view that matters most to markets. "Bond market will believe it when Janet says it," he said in an email to CNBC's Scott Wapner.

The real opportunity for Yellen to voice her views on rates and the economy comes June 6 when she has a scheduled speech on the economy. That will also be after the May employment report is released on June 2.

"Hawks and doves have been saying the same thing for the last two weeks and that would apply to Yellen," said Tom Simons, Jefferies money market economist. Three Fed presidents either spoke or were interviewed Monday, and each one delivered the same message: Rate hikes are coming if the data are strong enough. "They were all saying the same thing. If Yellen would say something different, that would be a stunner. The risk is she says nothing, not that she'll say something different."

Deutsche Bank chief U.S. economist Joseph LaVorgna said the Fed may be getting the markets set for a July hike, and were increasing the optionality of June because market expectations have been too low.

The Fed's meeting minutes specifically mentioned June as a time when the Fed could hike, but New York Fed President William Dudley last week said the Fed could hike in June or July. Some in the markets have now gravitated to July as the more likely of the two since then. The Fed funds futures reflect market odds of about a 30 percent chance for a June hike and 60 percent for July.

"We were at 4 percent chance of a hike 10 days ago, and now it's 30. If you get strong employment, the market is going to 50/50," said LaVorgna.

But the Treasury market is not pricing June yet, though the Fed sensitive two-year note yield has been edging higher from under 0.80 just two weeks ago. The government auctions $26 billion in two-year notes at 1 p.m. EDT Tuesday.

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"If they were going to hike in June, the two-year would be at 1 percent," said George Goncalves, head of rate strategy at Nomura.

"The market is saying if you're going to do it, we'll meet you on the odds that July is in play, but even then we're not behind that view. That's what the bond market is looking at. The way you break this feedback loop is to act boldly and hike fast to show you're in control of the bond market, but the bond market knows they don't want to do that because they're at risk of causing a recession."

Strategist do not expect a big reaction in the longer end, since negative yields and low rates in other parts of the world have made U.S. securities attractive.

As markets sort through the Fed's intentions, LaVorgna said the market will be focused on data this week that will give the best views of second-quarter GDP growth. The key piece of information will be advance international trade for April on Wednesday and the revisions to first-quarter GDP Friday. Tuesday's calendar is light with new home sales and the Richmond Fed survey, both at 10 a.m.

Strategists have said the apprehension in markets has been that there will be a violent reaction to the Fed's move forward, but so far it has been fairly calm. The dollar index (Intercontinental Exchange US: .DXY) Monday was flattish, and it is the dollar that could stir up the most trouble if it starts surging higher, hitting commodities and emerging markets.

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"We're basically trying to guess a three-month window of a Fed hike. Let's just say they're going to hike. We don't know if it's July or September when they want to hike," said Goncalves. "If they don't hike in July, they lose credibility. In June, people will give them a pass. June will be a 'hawkish' skip where they signal they were very close to hiking."

Many strategists rule out June because it is too soon and the Fed meeting is a week before the U.K. "Brexit" referendum on whether to remain in the European Union. Dudley said that vote could complicate the Fed's decision, and some strategists believe markets could get volatile if polls start favoring the split.

"They've gotten to another derivative of Fed communications. Now, they're trying to anticipate market reactions and get ahead of them," said Simons.

Goncalves said the about-face by the Fed is still being absorbed. "In fairness, four weeks ago they were so dovish and scared of the world. It was weird," he said, adding markets had been calming down weeks before the Fed's March meeting, yet the FOMC remained concerned about financial conditions.

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LaVorgna said if the Fed does hike in June and the markets are not prepared, the resulting reaction could force it to stay on hold. He said it's more likely the hike is late in the year. "If the market starts to price over 50 percent, and then we start to see financial conditions tighten dramatically … if they start really thinking it's June, then they're thinking of going two if not three times, that could really become self-reinforcing. Those conditions could move in a way that would make the Fed cautious," he said.

If inflation starts to pick up, that could get the Fed to move sooner. But it is so far muted.

"From the dove's point of view, the outlook continues to be a real challenge," said Rehling, who expects a hike later in the year. He said he doesn't expect inflation to start moving higher, and the Fed will likely wait.

"They've been taking their time. There seems to be little risk in waiting. You worry about inflation ramping up. There seems to be very low risk from that perspective. … They run the risk of the market not expecting that June rate rise," said Rehling. He said the dollar would strengthen, stocks would weaken. "The kind of factors that would support economic growth would turn the other way. I just see no reason for them to rush."

"We'll see what July brings. I don't see a reason for the Fed to be increasing here, unless it gets some real evidence the economy is starting to heat up a little bit," he said. "Obviously, the data we got earlier this year did not suggest that."

Earnings expected Tuesday include Volkswagen, Bank of Nova Scotia, Medtronic, Workday (NYSE: WDAY) and TiVo.

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