Has the Fed Ruined the Usual Christmas Rally with Its More Hawkish Outlook for 2025?

Fed Chair Jerome Powell. Image source: flickr.com

Yesterday's Federal Reserve decision to cut interest rates with 25 bps was initially seen as a welcome relief for markets. However, the more hawkish tone that accompanied this decision, particularly the revised plan for 2025, has cast a shadow over the usual festive rally in stock prices that markets have come to expect during the holiday season. The Fed’s move to reduce the originally anticipated four rate cuts in 2025 down to just two has left many wondering if the central bank’s cautious stance could disrupt the typical year-end rally in stocks, a period when markets historically perform well.

The Rate Cut: A Short-Term Relief

On December 18, the Federal Reserve made its much-anticipated decision to cut interest rates by 25 basis points, bringing the federal funds rate down to 4.50%. This marked the Fed’s third rate cut this year, and for many, it signaled that the central bank was inline with market expectations to continue loosening its monetary policy as a sign that inflation is under control. The rate cut was indeed a response to inflation coming down, and many market participants had hoped that it would usher in a more dovish outlook for 2024 and beyond.

Initially, the market reaction was positive. The immediate response from stock markets was a modest rally, with the S&P 500 and Nasdaq both posting gains. Investors cheered the rate cut, viewing it as a sign that the Fed was now more concerned with supporting economic growth and alleviating the pressure from high borrowing costs that had weighed on businesses and consumers alike throughout the year. However, any sense of relief was quickly tempered by the Fed’s forward guidance, which painted a more hawkish picture for the future than many had expected.

A More Hawkish Outlook for 2025

Despite the rate cut, the Federal Reserve’s outlook for 2025 took markets by surprise. In a move that caught many off guard, the Fed indicated that it was reducing the number of rate cuts initially expected in 2025. Previously, market consensus had anticipated four rate cuts over the course of 2025, which would have signaled a more aggressive easing cycle as the Fed sought to support the economy. However, the Fed’s revised guidance slashed this figure down to two rate cuts, a clear indication that the central bank remains concerned about inflation and is unwilling to commit to a more rapid easing of policy.

Fed Chair Jerome Powell emphasized during his press conference that while inflation had come down significantly from its peak, the central bank’s job was not yet finished. Powell pointed to ongoing concerns about core inflation, particularly in areas like services and housing, which have remained stubbornly high. He also noted that the labor market, while showing signs of cooling, was still relatively tight, which could continue to exert upward pressure on wages and prices.

The Fed’s more cautious stance sent a clear signal to markets: while it may be cutting rates now, the path to more accommodative monetary policy will be slow and gradual, especially if inflation remains sticky. This hawkish outlook for 2025 has created uncertainty, as investors must now recalibrate their expectations for future rate cuts and the trajectory of economic growth.

Impact on the Markets

The Fed’s hawkish pivot for 2025 had an immediate impact on financial markets. Stock prices, which had initially rallied on the rate cut news, began to retreat as investors digested the implications of fewer rate cuts than anticipated in the future. The S&P 500, which had been poised for gains, reversed course, and the Nasdaq followed suit. The technology sector, in particular, felt the brunt of the sell-off, as growth stocks are highly sensitive to interest rates. Higher rates, or even the prospect of fewer cuts, reduce the present value of future earnings, making tech stocks less attractive in a higher-for-longer rate environment.

The bond market also reacted strongly to the Fed’s updated guidance. Yields on longer-dated U.S. Treasuries rose, as traders adjusted to the idea that the Fed would keep rates elevated for a longer period. Higher bond yields tend to exert downward pressure on stock prices, as they increase borrowing costs for companies and provide investors with a more attractive risk-free alternative to equities.

The Christmas Rally: Still Possible?

The holiday season is typically a time of optimism in financial markets. The so-called "Santa Claus rally," which refers to the stock market's tendency to rise during the final weeks of December and the first days of January, is a well-documented phenomenon. Many factors contribute to this year-end rally, including holiday spending, tax considerations, and general market optimism heading into a new year.

However, the Fed’s more hawkish outlook for 2025 has raised questions about whether this year’s Christmas rally will materialize. While the rate cut provided some short-term relief, the revised guidance for future rate cuts has dampened enthusiasm. Investors are now grappling with the idea that monetary policy will remain tighter for longer, which could weigh on risk sentiment.

That being said, a Christmas rally is not entirely off the table. Historically, markets have shown resilience in the face of Fed tightening cycles, and the underlying economic fundamentals remain relatively strong. Consumer spending, which plays a key role during the festive period, is still robust, and corporate earnings, while mixed, have not shown signs of a severe downturn. Moreover, the seasonal effect of the holiday period, combined with thin trading volumes, could still provide a tailwind for stocks in the coming weeks.

Conclusion

While the Federal Reserve’s rate cut on December 18 initially sparked hope for a more accommodative policy environment, the central bank’s hawkish outlook for 2025 has introduced uncertainty that could weigh on markets. With the Fed reducing its planned rate cuts from four to two, the prospect of a slower path to monetary easing has cast a shadow over the traditional Christmas rally. However, the usual holiday optimism, along with strong consumer spending, may still provide markets with enough momentum to see gains before the end of the year. The next few weeks will reveal whether the Fed’s cautious stance will dampen the holiday cheer or if the markets can find reasons to rally despite the central bank's outlook.