If the Fed is hawkish this week, the rally in U.S. stocks may come to an end

A rate cut is widely expected in 2024, but if the Fed remains "hawkish" at Wednesday's meeting, investors' expectations change and equities could end the year.

Alex McGrath, chief investment officer at NorthEnd Private Wealth, believes that there is no upcoming report that will cause the Fed to change its monetary policy stance. He said expectations of a Fed rate cut next year have supported the recent rally in the stock and bond markets.

Since July 2022, the federal funds rate has remained in a range of 5.25% to 5.5%, a 22-year high. The U.S. stock market has seen a strong recovery in 2023 after a decline in 2022, especially with a sharp increase in November.

As of Friday, the Dow Jones Industrial Average was just 1.5% below its highest closing price about two years ago, according to Dow Jones market data. Meanwhile, the S&P 500 reached its highest close since March 2022. The Nasdaq hit a new closing high since April 4 last year. At the same time, the yield on the 10-year Treasury note fell sharply from a 16-year high of 5%, and the price of bonds rose.

But the market is divided on the direction of Fed policy. According to Melissa Brown, senior director of applied research at Axioma, Fed officials and investors have not yet fully agreed on when the Fed will begin to ease monetary policy. In addition, traders' forecasts for rate cuts have also been changing over the past few months, based on data from the Fed Funds futures market.

Friday's bond market performance suggests that investors may be reassessing the direction of interest rates in 2024. High-risk bonds, such as the JNK and HYG high-yield bond ETFs, which are often seen as indicators of market sentiment, have paused their rally due to falling benchmark borrowing costs, despite the large amount of money they have attracted in recent weeks. At the same time, the rise in 10-year and 30-year Treasury yields reflects investors' uncertainty about the future direction of the economy and policy since mid-October.

And, it is almost certain that the Fed will not cut interest rates at its last meeting of the year this week. The CME Fed Watch tool showed a 98.4% chance that the Fed would keep interest rates at 5.25%-5.5% at this meeting.

In addition, Nick Timiraos, a well-known financial journalist known as the "New Fed News Agency", also pointed out in his latest article:

Fed officials are unlikely to have a serious discussion about when to cut rates this week, and unless the economy is weaker than expected, it is unlikely that there will be any more (serious discussions) in the coming months.

Ed Clissold, chief U.S. strategist at Ned Davis Research, expressed doubts about the possibility of a rate cut early next year. He said the Fed's shift from tightening monetary policy to a gradual process will take place. The Fed is likely to gradually shift from a hawkish stance to neutrality before considering a rate cut.

Mike Sanders, head of fixed income at Madison Investments, is equally cautious. He believes that the market's expectations for a rate cut in March next year are too aggressive, and it is more likely that the Fed will start cutting rates in the second half of next year. He mentioned that the recent U.S. jobs report showed 199,000 new jobs added in November, beating expectations of 190,000, wages rose and the unemployment rate fell to 3.7%, the lowest in four months, given the continued strength of the labor market, which led to stubborn inflation in the services sector. Sanders believes the data shows that there are no signs of economic weakness that the Fed needs to act on to bring down inflation.

Sanders believes that the Fed may continue to be "hawkish". This attitude may be reflected in the "dot plot" interest rate projections to be released on Wednesday. In addition, although the Fed paused interest rate hikes in September, the statement reinforced its commitment to "maintain high interest rates for a long time". Sanders also stressed that inflation is likely to re-accelerate, and the Fed is more worried about inflation, so it is unlikely to ease policy prematurely. Ahead of the Fed's decision, updated data on the consumer price index (CPI) and producer price index (PPI) for November will be released, which will have a direct impact on the Fed's decision to cut interest rates.

It is worth noting that despite this, there are also positive voices in the market for the stock market. MarketWatch noted that seasonality could have a positive impact on the stock market in December. Based on historical data, the Dow Jones Industrial Average rose 70% of the time in December, whether bull or bear.

Clissold, chief U.S. strategist at Ned Davis Research, said the overall market outlook remains positive. He mentioned that if the US economy can achieve a "soft landing", it will help the current market continue to be bullish.