The Federal Reserve is once again facing unsettled markets as it prepares to raise interest rates for the first time in nine years, as investors grapple with a deepening slump in junk bonds and plunging energy prices.
Expectations that the Fed will go ahead and raise rates at its meeting Tuesday and Wednesday weren't shaken by a rough week that ended with a 1.8% decline for the Dow industrials on Friday. But the sense of stress in markets was unmistakable after oil prices fell 11% on the week in the U.S., the deepest drop since March, and the largest U.S. junk-bond exchange-traded funds posted sharp declines amid record trading volume.
For now, portfolio managers are viewing the action as merely a market correction rather than a sign of deeper distress. Many said they plan to buy securities at lower prices once the wildest market action abates. But few are saying they expect to jump in immediately, which is part of why analysts and traders said this holiday season is shaping up as the most volatile since the financial crisis.
"There are tectonic shifts going on in the marketplace, given what's happening in the credit market, the high-yield market, oil and the dollar," said Tom Carter, managing director at JonesTrading.
The heightened sense of anxiety is showing in a variety of market indicators. The CBOE Volatility Index, a measure of anticipated future swings in the S&P 500, hit 24.39 Friday, its highest level since late September.
The 10-year U.S. Treasury note traded Friday at 2.14%, its lowest yield since Oct. 28, as investors sought out havens.
Daily U.S. stock-trading volume this month has risen 11% from the comparable year-ago period, to 7.5 billion shares a day. Trading volumes this month are the highest since a deep stock selloff in August was tipped off by a nearly 40% decline in just over a month for the Shanghai Composite. The China selloff, begun on June 12, roiled markets around the globe as the Dow lost more than 6% of its value in August alone.
In the aftermath, however, markets rebounded.
Major contributors to the most recent declines include a sense of unease over the six-year-old economic expansion, marked by reports of softness. U.S. factory activity in November fell to the lowest level since the end of the recession.
Others include China's announcement Friday that it plans at some point to begin linking its currency to a basket of other currencies, easing a multiyear peg to the dollar, and the market's disappointment over the scale of the European Central Bank's latest stimulus plans.
Those anxieties were exacerbated late in the week, when long simmering concerns about risky debt were crystallized by the abrupt closure of the high-profile Third Avenue Focused Credit Fund. U.S. junk bonds posted their steepest one-day decline Friday since 2011, intensifying fears that a six-year bull market in stocks and other risky assets is nearing an end.
And then there's the Fed. Some traders said a rate increase is an important milestone on the long road back from the financial crisis and toward markets less dependent on central banks. But others said the expected move is likely to usher in an era of higher volatility in financial markets anyway.
"Many investors in the market have never experienced a rising rate environment, which only increases the chance for volatility to pick up next year," said Thomas Roth, executive director in the U.S. government bond trading group at Mitsubishi UFJ Securities (USA) Inc. in New York.
As in the August market upset, many traders are looking closely at swings in stocks for a hint of how coming weeks might play out.
The VIX, which is based on prices of S&P 500 options that investors tend to rush to when stocks decline, ended above its 10-year average of 20 and at its highest level since Sept. 30, signaling expectations for heightened stock swings over the next 30 days.
Futures contracts tied to the VIX also rose as stocks tumbled Friday. Analysts said they are signaling greater concerns about the near term than about periods further in the future.
VIX futures expiring a few months out are typically more expensive than VIX futures expiring in the current month, reflecting the rising chance of large stock swings or many other events over a longer period.
But contracts expiring this month are sharply higher than longer-dated futures. The VIX futures contract expiring next week rose to 23.65 on Friday, higher than the April VIX futures contract, which rose to 21.55.
That makes for a downward sloping futures curve, a phenomenon known as "backwardation" that is "a signal of short-term fear," said Ilya Feygin, managing director at WallachBeth Capital.
Friday's backwardation is the first since early October, said Michael Purves, head of equity derivatives research at Weeden & Co., following the stock-market tumult of August and September. This condition isn't unheard of and can last for a few days or a few weeks. But it's something that puts many market watchers on edge. "I wouldn't be rushing in to buy the market today," Mr. Purves said.
Another signal of stress: investors are betting that large U.S. companies will post bigger stock swings than their smaller peers. Typically, big companies are seen as more stable as they have several sources of revenue that could offset each other in different environments.
The VIX was higher on Friday following its 26% leap than the CBOE Russell 2000 Volatility Index, which gained 15% to 23.64 on Friday. The last time that happened was late September.
Write to Dan Strumpf at daniel.strumpf@wsj.com, Saumya Vaishampayan at saumya.vaishampayan@wsj.com and Min Zeng at min.zeng@wsj.com
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