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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 hitting 4.52% following the Fed meeting, their highest level in over six months, the rate outlook threatens to undermine the momentum for stocks, which are trading at elevated valuations.
"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.
"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.