The Fed Interrupted Trump's Stock Market Rally. What Comes Next?

The U.S. stock market’s post-election surge has encountered its first major challenge, as a pullback seemed inevitable following its remarkable rally after Donald Trump’s November 5 presidential election victory. While the retreat was anticipated, the question was what would trigger it. Federal Reserve Chair Jerome Powell stepped into that role with remarks on Thursday that gave investors pause.

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Speaking in Dallas, Powell reiterated that the Fed was not in a rush to implement another interest rate cut, emphasizing the resilience of the economy. This message echoed his stance following the Fed’s November 7 decision to lower rates by 25 basis points, a move that followed a 50 basis point cut in October.

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However, without the immediate optimism of the postelection rally, Powell’s comments appeared to resonate differently with investors, sparking concerns about the pace of future rate reductions and the broader trajectory of market interest rates. These considerations, particularly as they intersect with Trump’s economic plans, are expected to play a key role in shaping market dynamics in the weeks ahead.

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Major stock indexes responded to Powell’s comments by extending their modest losses on Thursday. By Friday, the sell-off deepened sharply, with the Dow Jones Industrial Average closing the week down 1.3%. The S&P 500 dropped 2.2%, while the Nasdaq Composite shed 3.3%. These declines followed a record-setting Monday for all three indices. Meanwhile, the small-cap Russell 2000, often seen as a primary beneficiary of “Trump trades,” suffered a significant weekly drop of over 4%.

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This retreat came on the heels of the best week of 2024 for U.S. stocks. Since the market closed on Election Day, the S&P 500 has gained 1.5%, the Dow has risen 2.9%, and the Nasdaq is up 1.3%. The Russell 2000, despite its recent decline, remains 1.9% higher over the same period.

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Powell’s remarks coincided with inflation data released earlier in the week that exceeded expectations slightly, as well as statements from other Federal Reserve officials suggesting that a December rate cut was far from guaranteed. These developments fueled a rise in Treasury yields, which had already been climbing following Trump’s election victory. Higher yields soon began to weigh on stocks.

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“Markets have largely shrugged off rising rates so far, with the S&P 500 climbing 6% since 10-year yields bottomed out two months ago. However, if the 10-year Treasury yield surpasses the 4.5% threshold, the equity market could face pressure, potentially leading to a near-term pullback,” said Larry Adam, chief investment officer at Raymond James, in a Friday note.

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On Friday, the yield on the 10-year Treasury briefly exceeded 4.5% before drawing buyers, ultimately closing near 4.46%. Adam remains optimistic, arguing that yields won’t pose a long-term problem for equities as long as corporate earnings maintain their upward trajectory and the economy achieves a “soft landing.”

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In the short term, however, equity markets may remain heavily influenced by movements in the bond market. Ian Lyngen and Vail Hartman, rates strategists at BMO Capital Markets, highlighted this dynamic in a note: “The feedback loop between higher Treasury yields and equity market volatility will dominate in the coming sessions. The absence of significant economic data will leave investor sentiment particularly vulnerable to swings in other asset classes.”

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The trajectory of Treasury yields, in turn, is tied to how investors interpret Trump’s economic agenda. Analysts have debated the extent to which the recent rise in yields reflects concerns over Trump’s proposed policies, including import tariffs, tax cuts, and continued government deficit spending. While Powell has emphasized that policymakers avoid making assumptions about fiscal policies, some experts suggest that uncertainty surrounding Trump’s plans could influence the Fed’s cautious approach to future rate cuts.

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Krishna Guha, head of global policy and central bank strategy at Evercore ISI, noted that the Fed is likely already considering potential reflationary shocks, shifting financial conditions, and reduced visibility into 2025. “These factors make Fed officials more sensitive to upside surprises in inflation data while incorporating Trump-related uncertainties they cannot openly address,” Guha wrote in a Friday note.

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Guha expects the Fed to implement another quarter-point rate cut in December, followed by a slower pace of one quarter-point reduction per quarter in 2025. While the federal funds rate is projected to fall toward 4%, the exact timing and scale of these cuts remain uncertain. This ambiguity is likely to dampen investor appetite for riskier assets at the margins.

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“Even under our base case, the Fed will prioritize maintaining flexibility as a hedge against uncertainties tied to Trump’s policies,” Guha added. “When the Fed opts for flexibility, risk-takers face reduced upside potential, making this environment less favorable for risk-taking, even if it isn’t as hawkish as some might fear.”

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