The Federal Reserve's Rate Hike Wasn't a Surprise -- So Why Did the Stock Market Drop Afterward?

On Wednesday, the Federal Open Market Committee, or FOMC, decided to raise interest rates for the third time this year and shared its latest opinions on the direction of rates and the economy as a whole. The rate hike and accompanying statement weren't much of a surprise, so the market didn't initially react much.

However, the market suddenly took a nosedive later in the afternoon, turning a roughly 100-point gain in the Dow Jones Industrial Average into a decline of approximately the same amount. The reason? While the Fed's actions didn't catch anyone off-guard, comments by Fed Chair Jerome Powell certainly did.

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The Federal Reserve meeting in a nutshell

You can read some important takeaways from the FOMC's meeting in an article I published shortly after the rate-hike decision was announced (but before Powell started his remarks). Just to sum it up:

• The target range for the federal funds rate was raised to 2% to 2.25%, a 25-basis-point increase, as expected.
• The Fed's rate-hike outlook for the rest of 2018 and 2019 stayed the same as well. The central bank is expected to raise rates again in December and another three times next year.
• The Fed's economic outlook has improved. GDP growth for 2018 is now expected to come in at 3.1%, up from the previous expectation of 2.8%. And the 2019 GDP growth outlook was revised upward by one-tenth of a percent.

What did Powell say?

When asked what economic conditions could make the Fed raise rates more aggressively than planned, Powell said that if inflation surprises the FOMC and heats up more than expected, the Fed would need to raise rates quicker than anticipated.

But, the FOMC doesn't think it's going to happen. "We don't see that," said Powell. "It's not in our forecasts."

The Fed's latest projections call for inflation to be about 2.1% for 2018, fall to 2% in 2019, and to rise to 2.1% for a bit. The central bank still sees long-run inflation settling at 2%, which happens to be the Fed's exact target. In other words, inflation is expected to be almost exactly where the Fed wants it for the foreseeable future.

Why did this comment make the market drop so quickly?

The short answer is that Powell's comment caused bond yields to fall, which in turn caused bank stocks to plunge.

Over the past month or so, bond yields have spiked, possibly in anticipation of faster-than-expected inflation. After all, inflation generally translates to higher interest rates.

As an example, the widely followed 10-year Treasury yield has risen from about 2.82% to 3.10% over the past month, excluding today's move. Most other U.S. fixed-income securities have made similar moves.

And when the FOMC initially announced the rate hike and released its statement and economic projections, there was no reason to think otherwise. As I mentioned, the Fed's GDP outlook for 2018 increased and the central bank indicated that it anticipates another rate hike in December. Both of these are consistent with the expectation for inflation to heat up.

So when Powell announced that the Fed is not forecasting higher inflation, the 10-year yield quickly dropped to about 3.06% -- a pretty significant move in a short time. Lower interest rates are generally bad for bank stocks, so the move sent the financial sector plunging. Most big U.S. banks dropped more than 1% for the day, and this was the major catalyst that sent stocks lower.