The rally in U.S. stocks faces a new hurdle: a potentially problematic rise in Treasury yields as the Federal Reserve announces fewer interest rate cuts for 2025.
The central bank’s interest rate outlook on Wednesday included only two cuts over the coming year, instead of the four previously forecast, catching investors off guard and sending stocks tumbling all year long. leading to a rise in yields and the dollar.
That overshadowed the Fed’s widely expected decision to cut its benchmark rate for a third straight meeting. The central bank raised its inflation forecast for next year, paving the way for higher-than-expected interest rates.
Fears that new President Donald Trump’s policies will further increase inflation are exacerbating uncertainty for markets.
Stocks were supported by expectations of looser monetary policy and had until now resisted the steady rise in Treasury yields. But with benchmark yields hitting 4.52% after the Fed meeting, their highest level in more than six months, the rate outlook threatens to sap momentum from stocks, which trade at lofty valuations.
“Rates are the biggest risk to markets going forward,” said Matthew Miskin, co-head of investment strategy at John Hancock Investment Management. “You had this period where the Fed had sort of declared victory…and the re-acceleration of inflation is forcing them to rethink all their progress.”
The Fed’s more optimistic outlook was immediately reflected in asset prices.
The S&P 500 ended down nearly 3% on Wednesday, its biggest one-day decline since August, while the tech-heavy Nasdaq collapsed 3.6%. However, the indices are still up 23% and 29%, respectively, this year.
“The Fed played the role of the Grinch today by resuming two rate cuts in 2025,” said Jamie Cox, managing partner at Harris Financial Group in Richmond.
In other assets, the Dollar Index rose to its highest level in two years after the meeting, while gold fell about 2%.
The path of monetary policy is closely monitored by investors because the level of rates influences bond yields and dictates borrowing costs.
Treasury yields, which move inversely to prices, have already risen in recent weeks ahead of the Fed meeting, with investors anticipating a “hawkish reduction” in which the central bank could signal a pause in the credit cycle. relaxation. Long-term bonds have also been shunned by some investors due to the deterioration of the US fiscal profile.
But the reduction in planned interest rate cuts, combined with Fed Chairman Jerome Powell’s cautious tone at the news conference following the monetary policy statement, left investors on guard.
“The markets are showing the Fed that they have lost a lot of credibility here,” said Jack McIntyre, portfolio manager at Brandywine Global. “They lowered rates, but failed to make a compelling case for doing so.”
Investors said benchmark yields crossing a key 4.5% level could cause turmoil for stocks and benefit less risky alternatives.
“Yields are going to become more problematic,” said Michael Mullaney, director of global markets research at Boston Partners, who expects the 10-year yield to hit 5% next year.
The S&P 500 was recently trading at 22 times earnings forecasts for the next 12 months, well above its long-term average of 15.8 times, according to LSEG Datastream.
“Since the start of 2023, stocks’ multiples have increased significantly, making them not only sensitive but also vulnerable to even small changes in Treasury yields,” said Jack Ablin, chief investment officer. at Cresset Capital.
Wednesday was the Fed’s final meeting before Mr. Trump takes office as president of the United States next month. Investors expect Mr. Trump’s policies to improve economic growth but also be inflationary, including his plans to raise tariffs on trading partners, posing another challenge to the capacity of the Fed to cut rates.
“On paper, his policies are inflationary,” Mr. Mullaney said.
Of course, many investors remain optimistic about the outlook for stocks, with the economy considered strong and corporate profits expected to rise more than 10% next year.
Jason Draho, head of asset allocation for the Americas at UBS Global Wealth Management, noted that the Fed still expects to cut rates, which is positive for stocks. The company is targeting an S&P 500 of 6,600 by the end of next year, about 12% higher than Wednesday’s closing level.
“The Fed still tends to cut rates,” Mr. Draho said. “It’s a direction that remains favorable to valuations, that remains favorable to the rise in stocks.
