Is a rate cut next week a done deal? Bank of America’s Hartnett warns that if the Federal Reserve adopts a dovish stance and cuts rates, it could end the Christmas rally in U.S. stocks

Bank of America strategists warn that the Federal Reserve's overly cautious economic outlook may threaten the year-end stock market rebound. The S&P 500 index is currently only about 0.5% away from its all-time high, but if the Fed signals excessive dovishness at next week's meeting, it may suggest that the economic slowdown is greater than expected, triggering a market sell-off.

On December 5th, Bloomberg reported that Bank of America strategist Michael Hartnett explicitly stated in a report, "The only factor that could stop the Santa Claus rally is a dovish rate cut leading to a sell-off in long-term government bonds." The swap market shows that investors' bets on a 25 basis point rate cut on December 10th have surged from 60% a month ago to over 90%, with traders fully pricing in the expectation that the Fed will cut rates three times before September 2026.

The Fed's decision next week faces a delicate balance. According to a Bloomberg survey, most economists expect the Fed to cut rates by 25 basis points to guard against the risk of a sharp deterioration in the labor market, but there are deep divisions within the decision-making body regarding the balance of inflation and employment risks, with a split vote expected.

This market test coincides with the arrival of two major risk events—key employment and inflation data will be released later in December, reports that have been delayed due to the government shutdown. The best-case scenario that current investors are betting on is that the Fed cuts rates while inflation declines and the economy remains resilient, but this optimistic expectation is about to be tested.

The market generally expects a rate cut, but dovish cuts carry risks

Morgan Stanley, JPMorgan Chase, and Bank of America have all shifted to expecting a rate cut in December this week, after previously anticipating that the Fed would remain on hold.

The shift in market expectations stems from weak economic data at the end of November, as well as dovish statements from key officials including New York Fed President and Federal Open Market Committee Vice Chair John Williams, Fed Governor Christopher Waller, and San Francisco Fed President Mary Daly.

Morgan Stanley strategists stated, "It seems our previous judgment was too hasty. We expect there will be dissenting votes, and Powell may adjust the wording of the statement in exchange for a rate cut, suggesting that the threshold for future cuts will be higher."

Morgan Stanley currently expects the Fed to cut rates by 25 basis points in January and April, with the terminal rate reaching 3.0%-3.25%, down from a previous forecast of one cut each in January, April, and June. JPMorgan expects another cut in January, while Bank of America predicts one cut each in June and July next year.

However, the Bank of America Hartnett team believes that overly dovish rate cut signals may convey the wrong message, suggesting that the degree of economic slowdown is greater than the market expects. Investors are currently generally anticipating a "Goldilocks" scenario: the Fed cuts rates to support a weak labor market while inflation continues to decline and economic growth remains resilient.

However, if the Fed reveals excessive concern about the economic outlook in its policy statement or Powell's press conference, it could trigger a sell-off in long-term government bonds, which would in turn affect the stock market. The S&P 500 index has risen 17% this year, although this performance lags behind the 27% increase of the MSCI All Country World Index excluding the U.S.

The Hartnett team advises investors to prepare for potential government intervention in the economy, expecting that the U.S. government will not tolerate overheating inflation or an unemployment rate rising to 5%. They recommend buying "cheap" mid-cap stocks and are optimistic about sectors related to the economic cycle, including homebuilders, retailers, real estate investment trusts, and transportation stocks

Disagreements Within the Federal Reserve Intensify

According to a Bloomberg survey of 41 economists, the vast majority of respondents expect another split vote next week, reflecting increasing tensions within the Federal Reserve's rate-setting committee.

Kansas City Fed President Jeff Schmid is expected to vote against again, having done so in the October meeting. More than one-third of respondents believe St. Louis Fed President Alberto Musalem will also vote against, as he has recently expressed concerns about inflation.

Fed Governor Stephen Miran is expected to vote against a 25 basis point rate cut again, having opposed it in the September and October meetings, advocating for a 50 basis point cut.

The divisions among decision-makers stem from differing judgments on the risk balance between price stability and full employment. Several regional Fed presidents have expressed concerns about persistent inflation, particularly the pass-through of price increases to consumers due to tariffs. Other officials believe there is still room for rate cuts to support the labor market.

In recent years, the Fed has reached monetary policy decisions through consensus. The survey shows that almost all economists now believe the Federal Open Market Committee is shifting towards a majority-rule decision-making process, although respondents are evenly split on whether there will be dissenting votes in the majority of meetings in 2026.

Economic Data Sends Mixed Signals

Economic data released since the last meeting has failed to provide clear guidance for decision-makers. Large companies like Verizon Communications and Amazon.com have recently announced large-scale layoffs, but weekly unemployment insurance claims data remains low.

The Bureau of Labor Statistics has yet to release an updated inflation report. The agency previously warned that due to the government shutdown for most of October and November, it will take time to resume regular economic data releases. The latest official data shows that the consumer price index rose 3% year-on-year in September.

Most economists believe that a significant weakening of the labor market remains the main challenge facing decision-makers, with only 18% of respondents considering more severe inflation to be a greater risk.

Fed officials will also release a new round of economic forecasts next week, with the median of the survey indicating that decision-makers may raise their economic growth expectations for this year while lowering inflation forecasts, and the unemployment rate forecast for 2026 may be slightly adjusted upward