By Lewis (JO:LEWJ) 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 instead of the four previously anticipated, catching investors off guard and sending stocks tumbling while driving up yields and the dollar.

This overshadowed the Fed's widely expected decision to reduce its benchmark rate for a third consecutive meeting. The central bank lifted its forecast for expected inflation next year, paving the way for higher interest rates than previously estimated.

Concerns that the policies of incoming President Donald Trump could further increase inflation are exacerbating uncertainty for markets.

Stocks have been buoyed by expectations of easier monetary policy and had largely ignored the steady rise in Treasury yields. However, with benchmark yields hitting 4.52% following the Fed meeting—the highest level in over six months—the rate outlook threatens to undermine the momentum for stocks, which are currently 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 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, marking its largest one-day drop since August, while the tech-heavy Nasdaq slid 3.6%. Despite this, the indexes are still up 23% and 29%, respectively, year-to-date.

"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 fell 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 inversely to prices, had already been rising 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 avoided by some investors due to the deteriorating fiscal profile of the United States.

However, the reduction in projected interest rate cuts, combined with a cautious tone from Fed Chair Jerome Powell during 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 a convincing case for doing so."

Investors indicated that benchmark yields breaching the 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 predicts 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 significantly, making them not just sensitive but vulnerable to even small changes in Treasury yields," remarked Jack Ablin, chief investment officer at Cresset Capital.

Wednesday marked the last Fed meeting before Trump takes office next month. Investors are preparing for Trump's policies to stimulate economic growth but also to inflate prices, including raising tariffs on trading partners, posing another challenge for the Fed's ability to cut rates.

"His policies on paper are inflationary," Mullaney added.

Nevertheless, many investors remain bullish on the outlook for stocks, with the economy seen on solid footing and corporate profits expected to grow 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 remains supportive for valuations and for stocks to rise."