By Lewis (JO:LEWJ) Krauskopf

NEW YORK (Reuters)

A banner year for U.S. stocks approaches a significant test with the upcoming Federal Reserve meeting, where investors seek guidance on interest rate cuts.

The Nasdaq Composite index recently surpassed 20,000 for the first time, marking another milestone as the tech-heavy index has gained 32% this year, while the S&P 500 has risen about 27%.

Expectations for Fed interest rate cuts have fueled these gains. While a cut of 25 basis points is anticipated next week, investors have tempered expectations for future aggressive cuts due to strong economic growth and persistent inflation.

In recent sessions, bond yields have risen, with the benchmark U.S. 10-year yield reaching a three-week high of 4.38% on Friday. Stocks have continued to rise despite increasing yields, but the 10-year yield is nearing 4.5%, a potential signal for market instability.

Jim Baird, chief investment officer at Plante Moran Financial Advisors, noted, “Anything that results in an expectation that maybe the Fed moves even more slowly than investors were expecting could create a little bit of downside for stocks.”

Investors closely monitor monetary policy trajectories as rate levels influence borrowing costs and stock valuations. Rate expectations also impact bond yields, which may lessen the appeal of equities, since Treasuries are considered virtually risk-free.

According to CME FedWatch data from Friday, Fed fund futures indicate a 96% likelihood of a 25 basis point cut during the meeting on Wednesday. However, future rate paths are less certain, with expectations suggesting a rate of 3.8% by next December, a notable increase from September estimates.

The Fed's summary of economic projections during the meeting will offer insights into policymakers' rate outlook. Back in September, officials envisioned a median rate of 3.4% by the end of the following year.

Fed Chair Jerome Powell mentioned a stronger economy than previously expected, which may lead to a cautious approach regarding future cuts.

Concerns surrounding potential strong inflation next year exist due to the presidential election of Donald Trump and his pro-growth economic policies.

BNP Paribas analysts anticipate a “hawkish cut,” suggesting the Fed may signal a pause for further cuts of unspecified duration.

Carol Schleif, chief market strategist at BMO Private Wealth, commented that “markets will be trying to read into how worried the Fed is about inflation.” Recent November data indicated stagnation in reducing inflation towards the central bank's 2% target.

Despite some market technicals indicating an overextension in stock rallies, analysts believe market momentum favors further gains leading into the year-end. Investor sentiment remains bullish, though the portion of Nasdaq constituents reaching 52-week highs has diminished since the post-electoral rally on November 5. Adam Turnquist, chief technical strategist at LPL Financial, suggests, “History indicates the tech-heavy index could require a breather before resuming longer-term momentum.”