Fed Shakes Up Global Markets as US Interest Rates Rise

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Signs the Fed could pull back on its easy money policies sent the dollar higher and interest rates rose to a two-year high, jarring stocks and other risk markets around the globe.

Major Asian stock markets were down about 2 percent and Europe's biggest markets were down 3 percent or more, while U.S. stocks dropped more than 2 percent in afternoon trading. Gold had one of the more violent reactions, falling under $1,300 per ounce, or more than 6 percent, after breaking the key $1,321 level. Gold settled at $1296 per troy ounce.

Selling picked up speed in afternoon trading after the S&P 500 fell through 1600, then 1598, the bottom of a support range, and a move that puts the next downside target closer to 1575, traders said. The S&P closed at 1588, down 40 points, or 2.5 percent, while the Dow tumbled 353 points, or 2.3 percent to 14,758, wiping out its May and June gains.

"It's freaking, crazy now," said one stock trader during the 3 p.m. ET hour as the Dow sunk more than 350 points. "Even defensive sectors are getting smoked. The super broad-based sell off between commodities, bonds, equities - I wouldn't say it's panic, but we've seen aggressive selling on the lows." The CBOE's Volatility index, the VIX, bounced 26 percent and was above 20 for the first time this year.

Some emerging markets were much harder hit, like Brazil, down almost 4 percent to a four-year low before recovering. Turkey was down 5 percent. Emerging market currencies were also slammed from India, to South Africa and Mexico. Weak manufacturing data from China overnight helped fuel selling in commodities and materials.

(Read More: Global Markets Feel the Sting of Fed's Tapering)

The 10-year Treasury yield rose as high as 2.47 percent, above a range it has been trapped in since August 2011. Yields were at about 2.4 percent in afternoon trading, but a close above that would be key to some technicians and could mean rates continue to move higher.

"I do think this is the beginning of a long-term trend in rising rates," said Ward McCarthy, Jefferies chief financial economist. "But I don't think this is the beginning of a longer-term trend of a decline in stocks. I think stocks will stabilize. Eventually, you're going to start to see a rotation out of fixed income into stocks, and stocks will rise."

Already, investors have been dumping bonds, since yields began moving higher in early May. ICI said there were more than $13 billion in outflows from bond funds last week alone.

"What we've seen now, and my concern is what we've seen now and my concern today is this negative feedback loop between mortgages and investment grade credit and Treasurys," said John Briggs, senior Treasury strategist at RBS. He said some of the selling in Treasurys came as traders hedged against a volatile mortgage market, which saw spreads initially widen, then narrow, then even widen again.

"My guess is this calms down … and then the importance of the economic data releases will become quite profound. As we sit today, I think the Fed's probably going to continue $85 billion per month through October and in October decide, they'll start the wind down in November," said McCarthy. Markets shrugged off improved data from the Philadelphia Fed and better home sales Thursday.

(Read More: Jobless Claims Rise as Factory Growth Slows)

"Rates are going to be higher over time. I think we'll be looking at 3 percent towards the end of the year. Right now, we're sort of going through an initial sea change," he said, adding that Bernanke first made it very clear the Fed could pull back on easing when he spoke to Congress on May 22.

"At least some folks seemed to hold out hope that Bernanke could stick the genie back in the bottle. No. 1, he could not do it, and No. 2, he didn't want to," McCarthy said.

Fed Chairman Ben Bernanke on Wednesday confirmed what markets had been expecting to hear—that the Fed could begin to taper back its $85 billion in monthly bond purchases before the end of the year if the economy improves enough.

He also said the purchases of Treasury and mortgage bonds could be completed by the middle of next year, but once it stops, the Fed would still be holding about $4 trillion in securities on its balance sheet.

"We're not talking about a tightening of monetary policy. The description he used was as the car accelerates, it's like taking the foot off the gas pedal, not braking," said Jim Steel, HSBC chief commodities analyst.

"If yields cease rising and the dollar flattens out that would signal a recovery in gold," he said. "We'll have to see. I think it's a bit of an overreaction. It's also summer and we probably have thinner conditions."

(Read More: Stocks Going Higher Despite Taper Talk: Pros)

Silver was even harder hit than gold, diving 8.4 percent, though platinum was off just about 4 percent. Steel said the steep drop in prices should mean physical buying will pick up in gold.

McCarthy said the markets also appear to be overreacting. "We're going to live with a large Fed balance sheet for a while. It's not like they're going to start sponging liquidity up," he said. Liquidity is going to keep floating around there for at least a couple of years. This is not tightening. They're basically managing the second derivative of a balance sheet policy."

The Fed is not expected to move to actually raise its Fed funds target rate from its current zero level until 2015.

—By Patti Domm, CNBC executive news editor.