By Lewis Krauskopf and Suzanne McGee

NEW YORK (Reuters) – The rally in U.S. stocks is hitting a new hurdle – a potentially problematic rise in Treasury yields as the Federal Reserve signals fewer interest rate cuts in 2025.

The central bank’s interest rate outlook on Wednesday called for just two cuts next year instead of the four previously envisaged, surprising investors and sending stocks tumbling while driving yields and the dollar higher.

This overshadowed the Fed’s widely expected decision to cut its key interest rate for the third time in a row. The central bank raised its forecast for expected inflation next year, paving the way for higher interest rates than previously forecast.

Concerns that new President Donald Trump’s policies could cause inflation to rise further are exacerbating uncertainty in markets.

Stocks were buoyed by expectations of looser monetary policy and had previously largely shrugged off the steady rise in Treasury yields. But with benchmark yields hitting 4.52% after the Fed meeting, their highest in more than six months, the interest rate outlook threatens to undermine momentum for stocks trading at lofty valuations.

“Rates are the biggest risk to markets from here on out,” said Matthew Miskin, co-chief investment strategist at John Hancock Investment Management. “There was this period where the Fed had sort of declared a victory… and the re-acceleration of inflation is forcing them to really reconsider any progress.”

The Fed’s more hawkish outlook had an immediate impact on asset prices.

The S&P 500 closed down nearly 3% on Wednesday, its biggest daily decline since August, while the tech-heavy Nasdaq fell 3.6%. However, the indices are still up 23% and 29%, respectively, this year.

“The Fed played the role of the Grinch today — rolling back 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 session, while gold fell about 2%.

The course of monetary policy is closely watched by investors because the level of interest rates influences bond yields and determines the cost of borrowing.

Treasury yields, which move in the opposite direction to prices, were already rising in the final weeks before the Fed meeting as investors anticipated a “hawkish cut” in which the central bank could signal a pause in the easing cycle. Long-term bonds were also avoided by some investors due to the deteriorating financial situation in the United States.

The story continues