By Lewis (JO:LEWJ) Krauskopf
NEW YORK (Reuters) - The Federal Reserve's first meeting of 2025 in the coming week stands to test the resurgence in U.S. stocks as investors gauge the extent of more equity-friendly interest rate cuts in the months ahead.
Stocks swooned after the Fed's last meeting in December, when the central bank downgraded its forecast for rate cuts as it braced for firmer inflation this year.
Since then, monthly data that showed underlying inflation moderated set off relief on Wall Street, helping drive a rebound in stocks with the benchmark S&P 500 hitting a record high this week.
The Fed is broadly expected to pause its easing cycle when it gives its monetary policy statement on Wednesday, with investors instead focused on "what would need to happen for them to start talking about resuming the rate cuts," said Angelo Kourkafas, senior investment strategist at Edward Jones.
Given recent data indicating strong economic activity, Kourkafas said, "there's wide expectations that the Fed has no urgency to continue cutting until we get potentially more encouraging inflation data."
The Fed's benchmark rate stands at 4.25% to 4.5% after the central bank lowered it by a full percentage point last year. The Fed's easing cycle began after rate hikes had helped bring down inflation from 40-year highs, although it remains above the Fed's 2% annual target.
Fed funds futures are pricing in about 40 basis points more of easing -- or nearly two more cuts -- by December, according to LSEG data.
Morgan Stanley (NYSE:MS) economists expect Fed Chair Jerome Powell will keep the possibility of a cut at the Fed's March meeting "on the table."
"If we are right in our assessment of the incoming data flow, then we think the Fed can stay on hold in January and retain its easing bias," the Morgan Stanley economists said in a note.
Meanwhile, President Donald Trump said on Thursday he wants the Fed to cut rates, even as the central bank is expected to pause for an uncertain duration.
Stocks have started the year strongly, with the S&P 500 up about 4% so far in January, following back-to-back years of gains of over 20%.
Investors this week digested a flood of activity by Trump after his second term began on Monday, including his announcement of private sector investment in artificial intelligence infrastructure that propelled a broad tech stock rally.
Some investors were surprised that Trump has not yet moved to enact new tariffs on foreign imports, a key part of his expected agenda that could set off broad market volatility. The president, however, is threatening an array of tariffs, which continues to keep investors on edge about the potential to increase inflation.
With the Fed meeting for the first time since Trump's presidency, the possibility of tariffs could factor into the central bank's outlook, said Larry Werther, chief U.S. economist of Daiwa Capital Markets America.
"If there's any hint that the Fed is perhaps taking a more solid view on tariffs... and it's unfavorable how they're viewing it with respect to potential inflationary pressures, I think it could potentially be a negative for equities," Werther said.
Stocks will also take their cues in the coming week from a slew of earnings results, especially from megacap tech companies. Reports are due from Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), Facebook (NASDAQ:META) owner Meta Platforms and Tesla (NASDAQ:TSLA) -- four of the "Magnificent Seven" companies whose shares have led equity indexes higher over the past two years.
The Magnificent Seven in general have put up stronger earnings growth than the rest of the S&P 500, but their valuations are also higher. The group trades at an average forward price-to-earnings ratio of 43 times expected 12-month earnings, and a median of 31.5 times, compared to 22 times for the S&P 500, according to LSEG data.
"If we start to see the Mag 7 struggle to meet some of these lofty expectations, we wouldn't be surprised to see if the valuations take a meaningful hit," said Michael Reynolds, vice president of investment strategy at Glenmede.