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Talk of higher interest rates spooks markets

| Thursday, March 20, 2014, 12:01 a.m.

NEW YORK — Higher interest rates are coming. And they are coming sooner than you think.

That's the message investors took away from the Federal Reserve on Wednesday. In response, they sent stocks and gold prices lower and bond yields sharply higher.

The Dow Jones industrial average lost 114.02 points, or 0.7 percent, to 16,222.17. The Dow fell as much as 209 points before erasing some of its loss.

The Standard & Poor's 500 index dropped 11.48 points, or 0.6 percent, to 1,860.77 and the Nasdaq composite lost 25.71 points, or 0.6 percent, to 4,307.60.

The Fed voted to cut its monthly bond purchases from $65 billion to $55 billion, in line with what analysts were expecting. Despite severe winter weather in January and February, the Fed said the economy has recovered enough for it to continue reducing the bond buys, which are aimed at keeping long-term interest rates low.

The Federal Reserve said the vast majority of its policymakers believed it would be appropriate for the central bank to raise short-term interest rates starting in 2015. The Federal Funds rate, traditionally the Fed's main tool for regulating the health of the economy, has been near zero since late 2008.

Investors have grown used to an easy-money policy from the Fed for more than five years now. Higher interest rates would mean the economy is improving, but it also raises the cost of borrowing money for everyone, from companies borrowing to expand their businesses to consumers looking at a mortgage.

At the same time, if the Fed kept interest rates too low for too long, it could cause the economy to overheat and experience inflation.

“We think they are acknowledging for the first time that short-term rates will rise in the future,” Chris Rupkey, chief financial economist with Bank of Tokyo-Mitsubishi UFJ, wrote in an email to clients. “And that future is not that far away. A normal economy will need a normal interest rate.”

Traders were confused when newly appointed Fed Chair Janet Yellen implied that the Fed's time frame for raising interest rates was closer to the first half of 2015, sooner than many had expected.

At a press conference, Yellen was asked how much time would need to pass between when the Fed ends its bond-buying program — which is expected to end in the second half of 2014 — and when the Fed would raise interest rates. Yellen responded that the Fed could consider raising interest rates in “six months or that type of thing” from when the bond-buying program would end.

A timetable of six months was much sooner than investors had predicted. So whether or not Yellen meant the “six months” as a definitive timetable or a rough estimate based upon where the economy might be in a year, the market took Yellen at her word, strategists said. Stock and bond prices steepened in their decline after she made her comments.

“It creates a haze of uncertainty,” said Andres Garcia-Amaya, global market strategist with J.P. Morgan Funds. “As we get closer to 2015, we should expect more volatility like this.”

The reaction to Yellen's remarks and the Fed's announcements was far more noticeable in the bond market.

The yield of the 10-year U.S. Treasury note, a benchmark for many kinds of loans including mortgages, rose to 2.77 percent from 2.67 percent Tuesday, a large move.

The U.S. dollar had its biggest one-day gain since August 2013, and gold had its worst day since December. In after-hours trading, gold was down $28.20, or 2 percent, to $1,330.80 an ounce.

Financial stocks did better than the rest of the market. Citigroup rose 80 cents, or 1.7 percent, to $48.94 and Bank of America rose 25 cents, or 1.5 percent, to $17.44. Banks, in particular big commercial lenders like Citi, benefit from higher interest rates because they can charge more for loans and credit card balances.

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