Uncertain liftoff as short-term interest rates start to rise

So far, so good. The Federal Reserve raised short-term interest rates off the floor for the first time in seven years on Dec. 16, and the sky didn't fall on financial markets.

Federal Reserve Chair Janet Yellen got high marks for delivering a clear message that emphasized the bank's still very accommodative policy stance, its sensitivity to global economic data and its flexibility on further rate hikes depending on the data.

"It's probably the most telegraphed move that the Fed has ever made," said Chris Gunster, managing director national fixed-income portfolio manager for U.S. Trust. Yellen's statement "was measured and guarded, and it was what the market wanted to hear," he added.

Compared to the last major shift in policy in 2013, when the Fed began reining in the quantitative easing bond-buying programs and caused the so-called taper tantrum in the markets, the Fed's first rate hike in almost a decade was gracefully executed.

"Yellen gets an A+ for the largest policy dismount in its history," said David Grecsek, director of investment strategy and research at registered investment advisor Aspiriant. "It's more symbolic than anything, but it gets us off the zero-rate policy."

The question now is: How far and how fast will the Fed's rate-hike cycle go? The bank's "dot plot," charting Fed members' expectations of future rates, suggests as many as four rate hikes in 2016 and a Fed funds rate of around 3 percent by 2018.

The bond market doesn't think so. The yield on the 10-year Treasury bond — 2.26 percent on Dec. 29 — has remained somewhat level since the Fed's move, and the market is pricing in only two rate hikes this year as a more likely scenario.

"It appears the Fed has a higher projected trajectory than the market does," said Gunster at U.S. Trust. "The difference will have to be worked out."

As for the possibility of a 3 percent risk-free rate by 2018, if the Fed sees its target inflation of 2 percent, experts think that's probably overly optimistic, too.

"I'd be surprised if there's enough momentum in growth and inflation to reach that level," said Rick Reider, chief investment officer of fixed income at BlackRock. "We expect the yield curve to flatten out and for the long end to move up only moderately from here."

Aspiriant's Grecsek also thinks the still uncertain outlook for the U.S. and global economies is likely to make this rate cycle an abbreviated one. "If U.S. economic fundamentals are strong enough to warrant a 3 percent Fed funds rate by 2018, that would be great, but we think it's more likely to top out between 1.5 percent and 2 percent," he said.

The Fed's move toward a more normal monetary policy (i.e., a real risk-free rate of return) is a vote of confidence in the economy, but it will present challenges for investors. For one thing, bonds may have negative returns this year.

"Retail investors have gotten used to positive returns in fixed income over the last 30 years," said Gunster. "We could see negative rates this year."

In every other rate-raising cycle, prices across most of the bond market have fallen.

While Gunster also expects the yield curve to flatten, very low coupon rates may not make up for price declines. "It's a different environment now, and that's a wildcard," he said. "The market's reaction to negative returns may cause more volatility."

The recent turmoil in the high-yield bond market is an early indicator of that. The shift in Fed policy is likely to result in more volatile equity markets as well. "Prices are high for all financial assets, which means there will likely be lower returns and spikes in volatility," said Grecsek. "We don't expect major market declines, but it could be bumpy."

An encouraging sign for the market, however, is that the Fed has proved that it's mindful of the bumps. The outlook for monetary policy remains extremely accommodative, as Yellen pointed out several times in her statement. The Fed has no plans yet to unwind its $4.5 trillion investment portfolio, reinvesting the money from maturing long-term bonds back in the markets.

Another factor that will likely keep the Fed cautious on rate hikes is that it's the only central bank currently tightening monetary policy. The slower growth in emerging markets and the collapse of commodity prices has most central bankers still cutting rates and supporting their economies.

While emerging markets have held up after the Fed's first rate hike, rising rates in the U.S. will attract capital from elsewhere — effectively putting a ceiling on long-term rates here.

The outlook for investment markets is a lot less clear going into 2016, but it's not likely to be the Fed that causes the volatility.

"Monetary policy has been a huge variable in financial asset returns for a long while," Grecsek said, adding, "If the Fed moves too far too fast, it will be disruptive. I don't expect they'll do that."

— By Andrew Osterland, special to CNBC.com