Bond Markets Don’t Expect a Dovish Fed. That Could Test the Santa Claus Rally for Stocks.

The Fed will cut rates on Wednesday. What is says after that will be crucial for Wall Street’s traditional Santa Claus rally. (Courtesy NYSE)

Key Points

• Investors anticipate a quarter-point Federal Reserve rate cut with 89% probability, but further cuts into 2026 are seen as unlikely.
• Steve Englander, head of North American macro research at Standard Chartered Bank, argues that Fed divisions, and Chairman Jerome Powell’s departure next spring, will add even more complexity to the rate outlook.
• Stocks largely have stalled since the selloff in bonds began late last month.

Bond markets have been signaling some discomfort on interest rates ahead of the Federal Reserve policy decision on Wednesday, with traders pricing in the likelihood of hawkish commentary from Chairman Jerome Powell that could blunt the chances for a late December rally in stocks.

Investors are in little doubt as to whether the Fed will deliver its final rate cut of the year, with the odds of a quarter-point reduction in the central bank’s key lending rate pegged at around 89%.

Follow-on cuts into 2026, however, are seen as increasingly unlikely, with the CME Group’s FedWatch indicating only one quarter-point reduction in the first half of the year.

However, as John Hardy, global head of macro strategy at Saxo Bank noted, the Fed heads into Wednesday’s meeting bereft of the kind of economic data it would normally have to justify both its policy decision and its near-term outlook for growth, inflation, and the labor market.

“The votes are clearly there for a cut, but with the key data still yet to be released until after (Wednesday’s) meeting, including the November jobs report and the November CPI inflation, guidance can’t be anything except cautious and data-dependent,” he said.

Investors also are likely mindful of comments from Powell that followed the Fed’s policy meeting in October, when he told reporters that a December reduction was “far from a foregone conclusion.” Little has changed on the data front since then, yet the odds of a rate cut increased from around 30% in mid-November.

Steve Englander, head of North American macro research at Standard Chartered Bank, argued that Fed divisions, and Powell’s departure next spring, will add even more complexity to the rate outlook.

“With new, likely more dovish, leadership coming, guidance on medium term policies lack credibility [and] investors may take future FOMC statements, press conferences and minutes commentary with a grain of salt,” he said.

Hawkish commentary from European Central Bank officials, including suggestions of a rate hike from Isabel Schnabel, executive board member, on Monday, as well as the telegraphed increases coming next week from the Bank of Japan, are also lifting bond yields in markets around the world.

That’s heaping pressures on U.S. Treasury bond prices, which move in the opposite direction of yields, and holding back gains in the stock market.

Benchmark 10-year Treasury note yields have risen by nearly 17 basis points over the past two weeks, and were last pegged at 4.16% heading into the Tuesday session. Longer dated 30-year bonds breached the 4.8% mark earlier this week, and were last changing hands at 4.791%.

Stocks largely have stalled since the selloff in bonds began late last month, with the S&P 500 rising just 0.5% since its pre-Thanksgiving close. The benchmark remains around 17% higher for the year, however, and just 55 points from the all-time high it recorded in late October.

Powering the traditional Santa Claus rally over the back half of December, with just 13 full trading days remaining, will be a challenge if Treasury yields continue to move higher.

Brian Buetel, managing director at UBS Wealth Management in Boca Raton, Florida, however, remains optimistic, and carries a 7500 target on the S&P 500 for the end of next year.

“We believe stocks can inch higher into year-end thanks to the expectation that rates will continue to move lower,” he said. “The combination of lower rates, artificial intelligence, more productivity and additional fiscal support from government spending on infrastructure, could help the markets achieve escape velocity in 2026.”

Write to Martin Baccardax at martin.baccardax@barrons.com