By Lewis Krauskopf and Suzanne McGee
NEW YORK (Reuters) -The rally in U.S. stocks is encountering a fresh hurdle -- a potentially problematic rise in Treasury yields as the Federal Reserve signals fewer interest rate cuts for 2025.
The central bank's rate outlook on Wednesday included only two cuts in the coming year, rather than the four previously penciled in, catching investors off guard, and sending stocks tumbling while driving up yields and the dollar.
That overshadowed the Fed's widely expected decision to reduce its benchmark rate for a third straight meeting. The central bank lifted its forecast for expected inflation next year, paving the way for higher interest rates than it previously forecast.
Concerns the policies of incoming president Donald Trump could further increase inflation are exacerbating the uncertainty for markets.
Stocks have been buoyed by expectations of easier monetary policy and had previously mostly shaken off the steady rise in Treasury yields. But with benchmark yields rising sharply after the Fed meeting, the rate outlook threatens to undermine the momentum for stocks, which are trading at elevated valuations.
The 10-year U.S. Treasury yield extended that rise on Thursday, hitting a 6-1/2 month high at 4.54%.
"Rates are the biggest risk for markets from here on out," said Matthew Miskin, co-chief investment strategist at John Hancock Investment Management. "You had this period where the Fed had kind of declared a victory... and the reacceleration of inflation is causing them to really have to rethink all the progress."
The Fed's more hawkish outlook immediately rippled through asset prices.
The S&P 500 ended down nearly 3% on Wednesday, its biggest one-day drop since August, while the tech-heavy Nasdaq slumped 3.6%. However, the indexes are still up 23% and 29%, respectively, this year.
That selloff rippled across world markets with European stocks falling around 1.5% on Thursday and MSCI's world stock index falling to its lowest in over six weeks.
"The Fed played the role of Grinch today — taking back two rate cuts in 2025," said Jamie Cox, managing partner at Harris Financial Group in Richmond.
In other assets, the dollar index soared to its highest level in two years following the meeting, while gold dropped about 2%.
The trajectory of monetary policy is closely monitored by investors, as the level of rates influences bond yields and dictates borrowing costs.
Treasury yields, which move in the opposite direction to prices, already were moving up in recent weeks ahead of the Fed meeting, as investors anticipated a "hawkish cut" in which the central bank might signal a pause in the easing cycle. Long-end bonds have also been shunned by some investors due to a deteriorating fiscal profile for the United States.
But the reduction in projected interest rate cuts combined with a cautious tone by Fed Chair Jerome Powell in a press conference following the monetary policy statement left investors wary.
"Markets are showing the Fed that they lost a lot of credibility here," said Jack McIntyre, portfolio manager at Brandywine Global. "They cut rates, but failed to make out a convincing case for doing so."
Investors said that benchmark yields breaching a key 4.5% level could cause turbulence for stocks and benefit lower-risk alternatives.
"Yields are going to become more of a problem," said Michael Mullaney, director of global markets research at Boston Partners, who projects the 10-year yield will rise to 5% next year.
The S&P 500 was recently trading at 22 times earnings expectations for the next 12 months, well above its long-term average of 15.8 times, according to LSEG Datastream.
"Since the beginning of 2023, the multiple on stocks has climbed quite a lot, making them not just sensitive but vulnerable to even small changes in" Treasury yields, said Jack Ablin, chief investment officer at Cresset Capital.
Wednesday marked the last Fed meeting before Trump takes office as U.S. president next month. Investors are bracing for Trump's policies to improve economic growth but also be inflationary, including his plans to raise tariffs on trading partners, posing another challenge for the Fed's ability to cut rates.
"His policies on paper are inflationary," Mullaney said.
To be sure, plenty of investors remain bullish on the outlook for stocks, with an economy seen on solid footing and corporate profits expected to rise more than 10% next year.
Jason Draho, head of asset allocation Americas at UBS Global Wealth Management, noted that the Fed still expects to cut rates, which is positive for equities. The firm has a S&P 500 price target of 6,600 by the end of next year, about 12% above Wednesday's closing level.
"The Fed is still biased towards cutting," Draho said. "It's a direction that still is supportive for valuations, is still supportive for stocks to be higher."
