The Federal Reserve surprised markets with its relatively hawkish outlook Wednesday after raising interest rates for the second time in 2017. Most Fed policymakers still expect another rate hike in 2017, and three more next year. The central bank also said it will start to normalize its massive $4.5 trillion balance sheet by year-end, with the details suggesting a slightly faster run-off that some had expected
Before the Fed announcement, market pricing implied no more rate hikes for another year, and stocks did not react well to Fed hawkishness.
The Fed's decision followed the latest in a series of surprisingly tame inflation reports. The Labor Department reported earlier in the day that core consumer price inflation, stripping out volatile food and energy prices, fell to a two-year low 1.7%.
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After the Fed's policy statement, the weak-Nasdaq, strong-Dow trade resumed as Fed Chair Janet Yellen elaborated on the U.S. central bank's views.
The Nasdaq fell 0.7% in late afternoon trade, while the S&P 500 fell 0.25%. But the Dow industrials turned up 0.2%, helped by rebounding banks.
Expectations of a slower rate-hike trajectory hit Dow component JPMorgan Chase (JPM), Bank of America (BAC) and other bank stocks ahead of the Fed announcement. But JPMorgan and Bank of America erased nearly all their losses by the close, with several banks turning positive.
Housing-related stocks were among the lead performers on the stock market today ahead of the news, thanks to the benign rate outlook. Homebuilder D.R. Horton (DRI) rose to a buy zone and hit an 11-year high, but pulled back somewhat as the markets soured. Home Depot (HD), another Dow component, climbed 1.8%, rebounding from its 50-day line. Whirlpool (WHR) gained 1.4%.
Fed policy expectations may continue to be volatile. On Tuesday, market participants were expecting the next rate hike by December. Before the announcement, they saw the Fed on hold until next June. The 10-year Treasury hit the lowest level since the week of the November election and the 2-year yield saw its sharpest single-day drop since Brexit, but yields rebounded somewhat after the Fed statement.
Even as the Fed has been on a tightening path, financial conditions have been easing, with the 10-year Treasury yield sinking about 50 basis points since mid-December.
While economists still expect inflation to firm in the months ahead, their confidence in that outcome is waning after broad weakness in airline, apparel, auto and medical care costs.
The Fed noted that inflation has been cooling, but Yellen said in her press conference that ebbing inflation appeared to be related to one-time changes, citing wireless data and prescription drug prices.
"On a 12-month basis, inflation has declined recently and, like the measure excluding food and energy prices, is running somewhat below 2%," the Fed said in its statement. The Fed lowered its inflation forecast for 2017 but expects inflation to hit its 2% target over the medium term.
Separately, the Fed detailed how it plans to reduce its balance sheet gradually. It'll let some expiring assets roll off the balance sheet, starting with $10 billion a month, or $6 billion from Treasuries and $4 billion from mortgage-backed securities.
Jefferies economists characterized the telegraphed balance-sheet reductions as "fairly aggressive" compared to expectations.
The caps will rise every three months by $6 billion for Treasuries and $4 billion for MBS until they reach $30 billion and $20 billion, respectively.
Officials didn't reveal the exact timing of when the process will begin this year, as well as specifically how large the portfolio might be when finished.
The CME Group FedWatch tool showed that markets now don't expect the next rate hike until March 2018. At that point, the Fed will likely have a new leader, with Fed Chair Janet Yellen's term ending in February.
With job growth running "well in excess" of the trend growth in the labor force, Yellen said it's prudent to remove accommodation to avoid having to tighten too quickly later.
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