What's Next For The Fed?

Markets now do not expect the Fed to go ahead with its planned interest rate rises this year. The federal funds futures market now shows traders are not expecting the Fed to raise rates until at least February of next year. At one point on Thursday, futures contracts were even pricing in a slight chance of a rate cut this year, and investors said some of the rally in gold prices resulted from the possibility of a rate cut.

The move in fed funds futures has been accompanied by a rapid decline in the spread between short-dated and long-dated U.S. Treasury securities. The difference between the 2-year Treasury note yield and 10-year note yield has narrowed to 0.95 percentage points, the tightest it has been since December 2007. The flattening of the yield curve has often preceded recessions in the past.

The narrowing yield curve spread shows investors are less confident of economic growth, even though Yellen told Congress on Wednesday that U.S. economy looks strong enough that Fed may stick to its plan to gradually raise interest rates.

"Part of the problem is that the Fed is in a no-man's land right now: not dovish enough for the doves and not hawkish enough for the hawks, so it's not satisfying any point of view in the investment markets," said Terri Spath, chief investment officer at Santa Monica-based Sierra Investment Management.

When Will The Fall End?

There are few signs yet that investors are dumping their holdings wholesale, typically a mark of a market bottom, said Alan Gayle, director of asset allocation at RidgeWorth Investments in Atlanta.

"It still seems to be focused on specific issues, whether it’s credit or it’s oil. But clearly there is a more defensive tone that the market is taking and we’re watching for signs of capitulation," he said.

Similarly, Credit Suisse noted that hedge funds have been selling in February, but the scope of that selling "lacks the much anticipated capitulation trade that would signal a bottom."

Credit Suisse also noted that macro-focused hedge funds have built up large U.S. equity short positions which have been a decent indicator of market direction in the past.