Will the Fed Launch or Kill the Santa Rally?

European markets got off to a bright start ahead of the Fed decision on Wednesday and U.S. futures are pointing to a similarly positive open, as investors reflect favourably on the prospect of a first rate hike from the Fed in almost a decade.

While the beginning of the tightening cycle should of course be viewed positively as it typically indicates strong economic performance, for a long time this has been more feared than welcomed as many have questioned the ability of the economy to withstand higher rates. Clearly that fear is passing though and investors are more optimistic now which is why we’re seeing markets rally ahead of the decision.

Whether this optimism turns into a full blown Santa rally or not will depend on the Fed’s ability to manage expectations and reassure investors than the tightening cycle will be very gradual. The reason why the Fed is raising rates now rather than when inflation returns to 2% – as per its preferred measure rather than core CPI which achieved this in November – is because it wants to avoid raising rates too quickly and this must be communicated very clearly again today.

It will be interesting to see how markets react initially to the Fed’s decision because with rates currently being between 0 and 0.25%. With a move to 0.5% currently being around 81% priced in, would markets be satisfied with the corridor being moved to 0.25-0.5% or would this be deemed to be a sign of weakness and hesitation from the Fed?

Whatever the decision, I expect to see plenty of volatility in the markets, especially as investors attempt to correctly interpret Chair Janet Yellen’s comments in the press conference which follows. Of course, the most volatility would likely come if the Fed gets cold feet like its European counterparts and pulls the plug altogether. This would cause huge credibility issues for the Fed given its clear intention to guide the markets to where they are today.