US stock investors have been enjoying an extended period of low volatility and steady gains, but with the Federal Reserve on track to raise interest rates this year and major indexes near records, the market could get a bit choppier in coming weeks.
Fed Chair Janet Yellen on Friday said she expected the US central bank to raise rates in 2015, though the process was expected to be gradual, with the timing of the first hike dependent on the strength of economic data.
Yellen's comments kept the likelihood of a September rate increase high. Currently, most economists expect lift-off in September, though dealers are not especially convinced of it. Market indicators put the first increase closer to the end of the year.
Recent data has been mixed. Some weak reports have pushed back the expected lift-off, but Yellen's words suggest the Fed is still headed to rate increases later this year.
"I thought the message was, 'if things stay like this, like they are today for a few more months, rates are going up.' And that is probably the correct policy call," said Stephen Massocca, chief investment officer at Wedbush Equity Management LLC in San Francisco.
When the Fed does raise rates, that will mark the first increase since 2006 and end a roughly six-year stretch of near-zero interest rates that has helped the stock market rally broadly to new records.
It has also kept a lid on long-term rates. The expectation that the Fed will raise rates soon, but keep the pace gradual, has been a boon for short-term rates and long-term rates, but less for the middle of the US Treasury yield curve. Five-year notes, which outperformed earlier this year, have lagged lately.
"We are of the camp that this rate cycle will be low and slow. The remarks from Yellen confirmed that," said Collin Martin, director of fixed income at Schwab Center for Financial Research in New York.
Analysts expect the Fed to move slowly and communicate its intentions often to avoid a "taper tantrum" of the variety caused by former Fed Chairman Ben Bernanke in mid-2013, when Bernanke surprised markets by suggesting the Fed could soon reduce stimulus. The Fed has let the federal funds rate drift higher, to around 11 to 12 basis points most of this year, from 9 to 10 basis points most of last year.
According to Bespoke Investment Group in Harrison, New York, in the three months after the Fed raises rates following a year of keeping them steady, the S&P 500 falls an average of 2.27 percent.
The market reaction this time could be amplified given valuation concerns. The S&P's forward price-to-earnings ratio is 17.5, well above the long-term average of 14.8, Thomson Reuters data showed.
"We are a little overvalued, even with interest rates low," said Donald Selkin, chief market strategist at National Securities in New York. "There could be some choppy seas ahead, especially if oil prices stay low or the dollar remains strong."
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