U.S. Stocks Jump While Bonds Drop as Markets Calmed by Rate Path

  • After 25 basis-point hike, Yellen stresses gradual approach
  • Ten-year Treasury yields fail to break last month's high

Fed Raises Interest Rates, First Time in Nearly a Decade

So far, so good. That’s what Federal Reserve Chair Janet Yellen must be thinking after watching the reaction in markets to the central bank’s first interest-rate increase in more than a decade.  

Rather than marking a turning point for investors, the mood was one of relative calm. Stocks built on gains from earlier in the session, the dollar advanced versus half of its major peers, and even emerging-market assets climbed with junk bonds. While Treasuries fell, yields on the benchmark 10-year note failed to rise above levels seen earlier this month, suggesting borrowing costs will be contained. Indications future rate hikes will come at a gradual pace supported gold as expectations for equity volatility slid.

Financial markets, reacting to the first rate increase since before the 2008 recession, reflected growing conviction among investors that the U.S. economy is strong enough to withstand higher borrowing costs, even as the threat of inflation increases. Gains built in equities over the afternoon as Yellen stressed the Fed’s gradual approach, noted signs growth is strengthening in developing markets and repeatedly dismissed concerns about inflation, saying wages showed evidence of strength.

“The market likes what she has to say,” said Michael Arone, the Boston-based chief investment strategist at State Street Global Advisors’ U.S. Intermediary Business, which oversees $2.4 trillion. “A few of the things I was looking for they came out and said: that conditions remain very accommodate and the pace of tightening will be gradual. This is a sign of their confidence in the U.S. economy.”

The Fed’s first rate increase in almost a decade came in a widely telegraphed move, with policy makers signaling that the pace of subsequent increases will be “gradual” and in line with previous projections. The decision ends an era of unprecedented monetary stimulus that pushed stocks higher by more than 200 percent and added $15 trillion in value during the 6 1/2-year bull market. Investors will now find out what stocks and the dollar are worth without the central bank stoking economic growth as aggressively.

“The Fed action relieves a lot of uncertainty,” John Carey, a Boston-based fund manager at Pioneer Investment Management, which oversees about $230 billion, said by phone. “There were still people with doubts, and now that’s behind us. Now it’s a question of listening to what they’re going to say. A slowly rising interest rate trajectory is now something that people can build into their forecasts with some confidence.”

Stocks

The Standard & Poor’s 500 Index pushed its gain past 1 percent as Yellen indicated that the economy could overshoot if the Fed hadn’t raised its target rate by 25 basis points.

The U.S. benchmark closed up 1.5 percent at 2,073.07 by 4 p.m. in New York. The rally was fueled by General Electric Co., which reached the highest in seven years after projecting the return of about $26 billion in cash to investors through dividends and buybacks. Utilities and telephone shares drove the advance.

The Chicago Board Options Volatility Index, a gauge of anticipated swings in the U.S. stock market, sank 15 percent to 17.86, its biggest drop since Dec. 4. Volatility surged last week as stocks had their worst period since August.

“It’s the Fed giving its seal of approval on the economy and financial conditions, but also the Fed didn’t surprise with more aggressive future path,’’ Stephen Wood, who helps manage $237 billion as chief market strategist for North America at Russell Investments in New York, said by phone. “This is a very dovish rate increase. It came right in in line with expectations.”

The Dow Jones Industrial Average climbed 1.3 percent, while the Russell 200 Index of small-cap shares climbed the most in a month. Futures on Asian indexes signaled gains, with Chicago-traded contracts on Japan’s Nikkei 225 Stock Average surging 2.5 percent.

When it comes to equities, history suggests two immediate consequences from Fed policy tightening: higher volatility and lower valuations, meaning earnings and ultimately the economy are left to drive prices. The Fed is raising rates at a time when profits are in decline, a combination that hasn’t occurred in five decades. 

Investors have spent the second half of 2015 coping with the first correction in four years and an increase in volatility that by some measures was a record. From plunging oil to emerging market turmoils and the selloff in junk bonds, anticipation of the Fed’s retreat added to anxiety that’s already pushed the VIX above levels at the start of past Fed liftoffs.

Bonds

Long-dated Treasuries were underwhelmed by the Fed decision, which brings the new target range for the federal funds rate to 0.25 percent to 0.5 percent from zero to 0.25 percent. Thirty-year Treasury notes yielded 3.01 percent, up just two basis points as policy makers signaled a gradual approach to rate increases amid tame U.S. inflation.

Two-year note yields touched a five-year high after the move, adding four basis points, or 0.04 percentage point, to 1.01 percent after earlier surging as much as five basis points. Ten-year yields rose three basis points to 2.30 percent, according to Bloomberg Bond Trader prices.

The most-accurate forecaster of the $13.1 trillion Treasuries market this year expects that lackluster inflation and tepid economic growth will limit the Fed to two rate increases next year. Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC, anticipates that 10-year yields will end 2016 at 2.22 percent. The median forecast in a Bloomberg survey is 2.78 percent.

Currencies

The greenback strengthened against the euro and the yen, while slipping against the Australian and New Zealand dollars after the Fed’s expected rate increase. The kiwi’s gains were fueled by a steeper-than-expected increase in quarterly economic growth.

The Bloomberg Dollar Spot Index, a gauge of the currency against 10 major peers, was little changed following four rising days. It has rallied more than 8 percent this year in anticipation of Wednesday’s move from Yellen and her group of officials.

Currency traders are on alert for a repeat of the dollar weakness that followed the start of tightening cycles in 2004, 1999 and 1994.

Emerging Markets

Emerging-market stocks rose the most this month and a Bloomberg gauge tracking 20 developing-nation currencies advanced for a third day. The MSCI Emerging Markets Index jumped 1.4 percent in a second day of gains following a nine-day rout. The index is still down by more than 17 percent this year.

“The U.S. market is taking the decision of the Federal Reserve as a positive sign, and this will be positive for emerging markets in the short term as well,” said Paul Christopher, global market strategist for Wells Fargo Investment Institute in St Louis. “The fact that the Fed will move gradually is reassuring investors in both developed and developing nations.”

The Turkish lira and the Mexican peso posted the steepest gains, rising at least 0.8 percent, while China’s yuan climbed 0.2 percent in offshore trading.

Brazil’s real retreated after Fitch Ratings handed Latin America’s largest economy its second junk credit grade, a move that may compel some institutional investors to dump the nation’s assets. The Ibovespa followed gains in global stocks.

Commodities

Oil tumbled after U.S. crude inventories climbed to the highest level for this time of year since 1930. Crude supplies rose to 490.7 million barrels, leaving stockpiles more than 120 million barrels above the five-year seasonal average, government data showed.

West Texas Intermediate oil for January delivery dropped 4.9 percent to $35.52 a barrel on the New York Mercantile Exchange. The U.S. benchmark slid below $35 a barrel Monday for the first time since February 2009 amid persistent concern over lack of action to curb a global glut in the commodity.

Gold extended gains, while silver surged and copper extended its climb. Higher rates normally reduce the appeal of metals, which don’t pay interest like competing assets. With gold trading near the cheapest level since 2010 and copper close to a six-year low, some traders say prices may be near a bottom as the focus shifts to the timing of the next U.S. rate increase.

“They’ve got it out of the way, they’ve got that zero rate off their back, and guess what? They haven’t caused any major dislocation in the market,” Lee Ferridge, head of macro strategy for North America at State Street Corp., said by phone from Boston. “I think they’ll be thrilled.”

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