The market calm on Wall Street was shattered Friday as stocks suffered their biggest slide since Brexit on fears an interest rate hike is around the corner.
The return of volatility was sparked by comments from Federal Reserve Bank of Boston president Eric Rosengren that suggests a September rate hike might not be totally off the table. The so-called "hawkish" commentary follows the European Central Bank decision this week to keep rates at current levels – a disappointment to investors who thought an additional stimulus was needed to get the eurozone economy moving again.
At the market close, the Dow Jones industrial average was down 394.46 points at 18,085.45 – its worst one-day drop since the 610-point slide on June 24 after the United Kingdom voted to leave the European Union – as investors fretted over the prospect of getting less support from the world's central banks.
The broad Standard & Poor's 500 index closed down 2.5%, ending a 52-trading day streak of not closing down 1% or more. The Nasdaq composite, which had its stretch of record closes snapped Thursday, fell 2.5%.
In a speech earlier Friday, Rosengren said: "My personal view, based on data that we have received to date, is that a reasonable case can be made for continuing to pursue a gradual normalization of monetary policy."
Those words rattled investors who had pretty much written off an interest rate increase at the Fed's Sept. 20-21 meeting following the weaker-than-expected August jobs report. Although Rosengren did not specifically mention September, his words leave the door open to a rate hike sooner than many investors expected. Low rates have been a key driver of higher stock prices.
John Canally, chief economic strategist for LPL Financial, said both the stock and bond markets have been "underpricing" the risk of a Fed rate hike this year, either in September or December. But Friday's sell-off puts the market more in sync with a Fed move sometime in 2016.
"We think at a 1-in-3 chance of a September hike and a 2-in-3 chance of a hike in December, that the market has now appropriately priced in a Fed rate increase," Canally told USA TODAY.
Prior to Friday's decline, it had been a quiet period for stocks, with volatility very low, a development that was starting to make some investors nervous. Heading into Friday's session the S&P 500 had gone more than 50 trading days without a drop of 1% or more, only the 48th time that has happened since 1950, according to Sam Stovall, U.S. equity strategist at S&P Global Market Intelligence.
So what's next? According to history "after going 50 days without a 1%+ decline, the S&P 500 slipped an average 1.5% in the following 20 trading days and fell in price two out of every three times," Stovall wrote.
A closely watched Wall Street "fear" gauge, dubbed the VIX, jumped 39% to a level of 17.33. It was the CBOE volatility index's highest level since June 28. Still the daily bump up in fear Friday was less than the 52% rise on June 24 after the Brexit vote on June 23.
But Canally says the return of volatility may be here to stay. "Volatility, which has been abnormally low since mid-February, may begin to pick up as we approach the election and move closer to the end of the business cycle," he says.
Interest rates on long-term U.S. government bonds also shot up on fears of a coming rate hike, perhaps as early as the Fed's Sept. 20-21 meeting. The yield on the 10-year Treasury bond ticked up as high as 1.675, its highest level since June 24, when shocked markets reacted to the Brexit vote a day earlier.
Some market pros say investors should not overreact to Friday's sell-off.
"Right now, the biggest risk investors face isn't volatility but the urge to overreact to it; keep calm and carry on," says Brad McMillan, chief investment officer at Commonwealth Financial Network.