Markets are at an inflection point, digesting the idea of higher interest rates now that the Federal Reserve has set the stage to end the extraordinary bond-buying program it undertook to help the economy and revive the housing market.
Comments from Fed Chairman Ben Bernanke Wednesday that the Fed could begin to cut back on purchases later this year sent Treasury yields higher, gold lower, the dollar higher, and stocks spiraling downward, as the markets adjusted to the idea of a higher rate environment. The 10-year yield reached 2.35 percent, its highest level since March, 2012. The Dow fell 206 points to 15,112 and the S&P 500 was off 22 to 1628.
"What's got (stocks) spooked here is what's happening in other assets," said Art Cashin, director of NYSE floor operations at UBS. "If you look at the currencies, they exploded, the Brazil real and a couple of others.The yield on the 10-year is also moving up…Stocks are being influenced by machine-gun moves in a number of other things."
Trading could remain volatile Thursday, after global markets react to the moves in the U.S. and PMI data in China and the euro zone. U.S. stock futures were only slightly changed in evening trading Wednesday.
Because Bernanke re-emphasized that the Fed's decision to slow down easing will be dependent on improvements in economic data, traders will stay hyper-focused on economic reports, especially anything jobs-related. On Thursday, jobless claims are reported at 8:30 a.m. ET, and manufacturing PMI is reported at 8:55 a.m. There is also existing home sales, the Philadelphia Fed survey and leading indicators, all at 10 a.m.
David Ader, chief Treasury strategist at CRT Capital, said he believes the Fed Wednesday signaled a significant shift for bond investors. There has already been an exodus from all types of bond funds, and ICI reported Wednesday that bond funds saw outflows of $13.5 billion last week.
"The dust is going to have to settle on this thing. It's not today, it's not tomorrow. Are people going to say 'I'm a bear. We've been shown the future and I'm just not going to be a buyer?'" he said. "That's possible…There's just no way the Fed can extract this accommodation without causing pain and causing higher interest rates…That does not mean we won't see 2 percent or 2.05 percent (10-year) yields again but in broader terms, we've got a turn going on."
Ader said he expects the market to be choppy, particularly as it gets closer to when the Fed might start cutting back on purchases. "I think the path to a 3 percent 10-year note yield will take nine to 12 months. I think this is going to be a long, drawn-out event, but I think that's where we're going. The market still has a bit of a short in it," he said.
(Read More: Gundlach: Bet on a Most Hated Asset)
Fed officials have been talking about winding down the $85 billion in monthly purchases of Treasurys and mortgage securities, and Fed watchers had pieced together forecasts for how the wind down might look, but they were waiting for the Fed's statement and Bernanke's comments Wednesday to clarify the Fed's intentions. Bernanke's timing for the slowing of the bond-buying program fit many of the forecasts on Wall Street, yet the markets moved anyway. Even if the Fed stops buying bonds, it will still be holding more than $3 trillion on its balance sheet.
"They don't tie themselves officially into anything but it's clear what they're going to do," said James Paulsen, chief investment strategist at Wells Capital Management. "I think he's more clearly said today than at any other time that he's going to taper before the end of the year, and there's a possibility he could be done by the middle of next year."
Paulsen said the higher rate environment does not have to be a negative for stocks, once the market adjusts. He pointed out that the worst-performing stocks Wednesday were those with traits like bonds – higher yielding, defensive sectors. Telecom was down 2.7 percent and utilities were down 2.3 percent. While also trading lower, the sectors that were the best performing Wednesday were cyclicals, materials, energy and tech.
"I think stocks are going to do okay with this. I have said we're in a trading range. It's going to digest higher yields and tapering, but I don't think it's going to go down a lot," Paulsen said. "At the end of the day, from a stock investor perspective, this is more of a celebratory milestone than a scary event…Even the Depression scaredy-cat Fed is saying thinks are looking a little better. That speaks volumes. This is something that as a stock investor, we all wished and hoped for."
Richard Bernstein, CEO of Richard Bernstein Capital Management, said he still remains relatively bullish on stocks. "It's our view, profits are likely to rebound," he said on "Closing Bell." "Therefore, we remain relatively bullish. All that's happening is that interest rates are winning the tug of war right now and you don't have the positive earnings to pull back the other way."
Barclays and Citigroup economists both said in notes following the Fed meeting that they expect tapering after the September Fed meeting. J.P.Morgan economists said the Fed and Bernanke sounded more confident in the outlook and the economy, particularly in the statement where it said the "downside risks to the outlook for the economy and the labor market as having diminished since the fall."
The Fed also trimmed its forecast on unemployment to fall to 7.2 to 7.3 percent this year, down from its earlier view of 7.3 to 7.5 percent. The unemployment rate was 7.6 percent in May. For 2014, it sees unemployment at 6.5 to 6.8 percent, and it expects an unemployment rate of 5.8 to 6.2 percent in 2015. The Fed has said it would look to raise its target Fed-funds rate once unemployment gets to 6.5 percent, and most Fed officials forecast the first rate hike to be in 2015.
(Read the full Fed Statement Here)
"Our perception of the Fed's criteria for tapering has changed. At his press conference, Chairman Bernanke indicated that the FOMC wishes to conclude the asset-purchase program when the unemployment rate reaches 7.0 percent and to start tapering later this year if the unemployment rate remains on a downward trend. Even though we continue to be less optimistic than the FOMC on growth (which we thought would delay Fed tapering into early 2014), we continue to expect a faster decline in the unemployment rate, based on our view that the labor force participation rate will not rise significantly," wrote Barclays economists.
They now see the Fed beginning to pare back asset purchases, starting with a reduction to $70 billion at the September meeting, and they expect it to end in March, sooner than Bernanke suggested.
Stephen Stanley, chief economist at Pierpont Securities,said he was surprised to see Bernanke be so explicit. "I'm happy they've done it. They added some clarity, but it limits their wriggle room a little bit.Even if they never admit a big reason they want to cut back on QE is the financial market angle," he said. Some Fed official have expressed concerns that there financial stability could become an issue from markets overreacting to quantitative easing.
"I think it's a pretty big deal. They're pretty far along in the process of coming to the idea that it's time to start curtailing QE," he said. Stanley said the Fed is worried about federal spending cuts or sequestration and what that could do to the economy. "I think they were kind of in a definite holding pattern for the last few months, and probably for the next month or two just to allow the economy to get through this period where the sequestration has its maximum impact."
(Read More: Bernanke Stays Mum on His Exit Strategy)
What Else To Watch
PMI manufacturing data is released for the euro zone Thursday morning, and China's PMI data is released overnight New York time.
Kroger and Rite-Aid report earnings ahead of the opening bell, and Oracle reports earnings after the close.