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Why the Fed switched to a slower track

Wednesday's Federal Reserve policy announcement resulted in serious fireworks in the financial markets. The takeaway: Nearly every asset class surged, thanks to a smash lower in the U.S. dollar as the Fed struck a dovish note.

In response to a tightening labor market, the Fed set the stage for rate hikes potentially as soon as June by removing the "patient" language from its statement. But it also acknowledged recent economic weakening and softness in inflation (caused by falling energy prices and a rising dollar) by lowering its "dot plot" projections of individual interest rate estimates. That's what caused Wednesday's rip higher to recover from early session losses.

In the end, the Dow Jones industrials gained 1.3 percent to close at 18,076 after trading in a 400-point range. The small-cap stocks in the Russell 2000 gained 0.8 percent to close at a new all-time high of 1,252.

The Fed statement itself was largely boilerplate, noting further improvement in the labor market and reasonable confidence that inflation would move back to the Fed's 2 percent target. The bigger story was what happened with the Summary of Economic Projections, or dot plot. Fed policymakers dramatically cut the median estimate of where rates will be at the end of the year from 1.2 percent to 0.6 percent.

Translation: The Fed is only looking for two rate hikes this year, down from four back in December.

Moreover, the end-2016 estimate was cut to 1.9 percent from 2.5 percent prior and the end-2017 dropped to 3.1 percent from 3.7 percent.

In addition, the Fed lowered its 2015 GDP growth forecast (a range of 2.3 percent-2.7 percent from 2.6 percent-3 percent), headline inflation forecast (0.6 percent-0.8 percent vs. 1 percent-1.6 percent) and "full" employment rate (5 percent-5.2 percent from 5.2 percent-5.5 percent). All this suggests the Fed is suddenly looking a lot less hawkish on monetary policy for the rest of the year.

The motivation for the change has a few moving parts.

For one, severe winter weather and a run of disappointing economic data has pushed down the Atlanta Fed's GDPNow real-time estimate of first-quarter growth to just 0.3 percent.

Two, the 25 percent gain in the dollar since last summer -- encouraged by the relative strength of the U.S. economy compared to Asia and Europe and new monetary policy stimulus measures by foreign central banks -- has had a chilling effect on inflation and export growth. The Fed, by acting dovish, leaned against this rise.

That raises the risk that foreign central banks will respond (the Swedes preemptively cut interest rates deeper into negative territory Wednesday morning), adding to talk of a currency war as countries fight to weaken their currencies in an effort to juice exports and employment. Volatility is on the rise, with the dollar suffering a large "flash crash" like decline in after-hours trading.

And three, for months there has been a disconnect between the Fed's old interest rate projections (four rate hikes for a 1 percent increase) and the market's projections based on futures market pricing (one rate hike toward year-end).

The Fed blinked first, moving its dot plot down closer to where traders were.

For a market that's extremely dependent on the flow of cheap money from the Fed, this was like manna falling from the sky. Asset prices reacted accordingly with stocks, bonds, foreign currencies, precious metals and industrial commodities all rocketing higher.

The question now is: Will the gains stick?

This feels very similar to the unexpected market surge back in September 2013 as the Fed -- to the surprise of pretty much everyone -- held off on tapering its now-ended QE3 bond-buying program. The Fed shocker capped a multiweek rise for stocks after which the Dow slid nearly 6 percent.

The plunge in the dollar after the close could be the start of a bout of intense currency market volatility -- something that won't sit well for hedge funds engaged in popular currency carry trades. For instance, stocks have shown a tendency to trade in unison with the relationship between the Japanese yen and the U.S. dollar, rising when the dollar rises against the yen. Should the dollar weaken dramatically against the yen, as it is now, then these carry trades will suffer.

Now, attention will turn to the Fed's June meeting -- and the flow of the economic data between now and then -- to determine when the policymakers will raise interest rates for the first time since 2006. Aneta Markowska at Societe Generale is looking for a rate hike in June and one in the fourth quarter. Joseph LaVorgna at Deutsche Bank believes liftoff will occur in September with another rate hike later in the year.

It won't be too long before we know for sure.

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