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Here is how the Federal Reserve could spark a ‘Santa Claus’ stock rally

A man dressed as Santa Claus Credit: BORIS HORVAT/AFP/Getty Images
A man dressed as Santa Claus Credit: BORIS HORVAT/AFP/Getty Images

After a bruising few months for stocks, investors are banking on a ‘Santa Claus’ rally to close out 2018.

Even with just a handful of trading sessions left in 2018, there is still one remaining catalyst that could spark a stock rally: the Federal Reserve.

The market is pricing in a 78% chance the Fed announces a rate hike Wednesday, when it wraps up its two-day policy meeting, according to CME futures data.

The rate hike itself wouldn’t spark the rally. In fact, rate hikes make stocks less attractive. But this rate hike is so priced in, that not going forward with it could signal that the Fed is worried about the economy. This would be the Fed’s fourth interest rate hike of 2018. It was in June that the Fed telegraphed this fourth rate hike.

Instead, the stock rally could be sparked by the Fed’s guidance about monetary policy in 2019.

“For U.S. stocks to drift higher this week, the Fed will have to strike an easier tone about future rate hikes without signaling undue concerns about U.S. economic growth,” wrote Nick Colas, co-founder of DataTrek Research, in a note to clients Monday.

But doing so may force them to downgrade U.S. economic growth forecasts for 2019, Colas said.

“Changing course on rates without that air cover will make it look like the Fed is targeting asset price volatility (a.k.a. the “Fed Put”) or - worse - that the central bank is taking orders from the White House,” Colas noted, referring to President Trump’s months-long criticism — which occurred as recently as Monday — of the Fed’s monetary tightening.

The Fed is currently forecasting 2.5% GDP growth for 2019. Fresh projections from the Fed are due Wednesday.

If Colas is right, the question becomes: Will the market be able to brush off a dimmer economic outlook in exchange for a more dovish interest rate outlook?

Meanwhile, the Fed’s statement on Wednesday, roughly 200 words in length, will be scrutinized by investors.

“The Fed could delete the words ‘gradual increases’ — meaning a hike every quarter is no longer a working assumption,” said Danielle DiMartino Booth, a former Fed advisor and CEO of Quill Intelligence, in an interview with Yahoo Finance. “That would take March off the table in theory and could spark a rally, even if based only on technicals, that could run into year-end.”

The Fed has started to use the phrase “gradual increases” when referring to interest rate hikes in its statements starting in June. Prior to that, many of the statements included the phrase “gradual adjustments.”

“Investors are hungry for even a morsel of dovishness, and what they do not say could be even more powerful than what they do say,” Booth noted.

For investors looking to play the possible ‘Santa Claus’ rally, Colas sees technology stocks as the biggest beneficiary.

The tech-heavy Nasdaq Composite (^IXIC) is down 15.5% since its Aug. 31 high.

David Bahnsen, chief investment officer and managing partner of The Bahnsen Group, is eyeing this stock playbook if the Fed issues more accommodative language on Wednesday:

  • Emerging markets on dollar reversal and hopeful trade resolution

  • Financials on stabilized, if not widening, yield curve

  • Energy on capital expenditure boom and China trade imports

And for investors worried about how time is running out for a year-end rally, the traditional definition of a ‘Santa Claus’ rally is the last five trading sessions of December and the first two trading sessions of January.

There’s still plenty of time to rally.

Scott Gamm is a reporter at Yahoo Finance. Follow him on Twitter @ScottGamm.

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