*

Muted initial market reaction gives way to sharper moves

*

Small cap stocks up sharply

*

Bond yields spike

(Updates comments, details in paragraphs 4-10; updates prices

throughout)

By Saqib Iqbal Ahmed, Suzanne McGee and Carolina Mandl

NEW YORK, Sept 19 (Reuters) -

A muted market reaction following the Federal Reserve's

first rate cut in four years is giving way to a surge in U.S.

stocks as uncertainty eased and investors digested the

implications of an easing monetary policy trajectory.

The S&P 500 was up 1.3% on Thursday, hitting a fresh

intraday high, a sharp contrast to the day before, when the

benchmark index closed down 0.3% following

a 50-basis point rate cut

from the Fed. Treasury yields, which move inversely to bond

prices, continued to rise.

The Fed meeting had been seen as a potentially pivotal event

for markets, with rates futures gyrating hours before the event

as traders recalibrated bets on how big the initial rate cut

would be.

With the first rate cut now in the books and a better

idea of the Fed's monetary policy trajectory going forward,

investors can turn their focus to factors such as corporate

earnings growth, which has been solid this year, said Michael

Purves, CEO of Tallbacken Capital Advisors.

"If stocks are rallying, it's more about the fact that

the Fed meeting is behind us," Purves said.

At the same time, investors may also be factoring in

better chances of an economic soft landing, where the Fed is

able to cool inflation without badly hurting growth, now that

monetary policy is less restrictive, said Ed Yardeni, founder of

Yardeni Research.

"Now that the Fed is stimulating the economy, the

hard-landing crowd should disperse," Yardeni wrote in a Thursday

morning report.

Lower rates are likely to benefit smaller, highly leveraged

companies that rely on cheaper debt as well as economically

sensitive-value stocks, Yardeni said. The rally that has pushed

the S&P 500 up 18.5% this year will likely broaden from the

cluster of big tech names that have led the gains, he added.

The small-cap focused Russell 2000 index was up 1.4%

on Thursday morning after finishing about flat in the previous

session.

Historically, equities tend to respond well to falling

rates, as long as a recession is avoided, according to data from

Keith Lerner, co-chief investment officer at Truist Advisory

Services, which showed the S&P 500 higher a year after the first

cut in four out of six Fed easing cycles since 1989.

That doesn't exclude the possibility of volatility in the

shorter term, however, as the Fed decision ripples through

markets.

"The coming hours could prove dangerous ... with traders

exposed to sudden riptides as rate expectations are reinforced

in other economies," said Karl Schamotta, chief market

strategist at payments company Corpay ( CPAY ), commenting on

foreign-exchange markets.

The dollar was little changed against a basket of currencies

on Thursday, hovering near its lowest level in about a year.

Investors were also looking ahead to Friday, when the

quarterly expiration of stock options, stock index options and

futures - totaling some $5.1 trillion in notional terms,

according to SpotGamma - ramps up the risk for volatility in

equities as traders adjust their positions.

MUTED REACTION

Stock options had priced in a roughly 1.1% swing, up or

down, for the S&P 500 on Wednesday, according to options

analytics service ORATS. But by the close of trading on

Wednesday, the index had snapped a seven-day winning streak to

finish down 0.29%, reversing earlier gains.

One reason for the muted market reaction on a close-to-close

basis has to do with how asset prices moved in the days leading

up to the Fed decision, said Sonu Varghese, global macro

strategist at Carson Group.

Through Tuesday, the Russell 2000 was up 5% over the

previous five sessions and the dollar had slipped 0.7%, on

expectations for the start of the Fed's long-awaited

rate-cutting cycle.

"It's a very silly cliche, 'buy the rumor, sell the news',

but that's kind of what happened," said Matt Diczok, head of

fixed income strategy at Merrill and Bank of America Private

Bank.

Treasury yields, which rise when prices fall, kept rising on

Thursday with benchmark 10-year yields up to 3.75% and two-year

yields rising to 3.62%.

The move was exacerbated by weekly jobs data showing

continued strength in the labor market.

With the Fed meeting in the rear view mirror, "attention

will once again shift toward the incoming data to further refine

the macro narrative," BMO Capital Markets rates strategists said

in a note.