December 9, 2016 / 9:33 PM / 7 months ago

Hawkish Fed a potential speed bump for stock bulls

NEW YORK (Reuters) - Next week's Federal Reserve meeting and possible signals on the pace of rate hikes for next year could pose the biggest risk yet to the rally the U.S. stock market has seen since last month's presidential election.

While investors have long anticipated the Fed will raise rates at the Dec. 13-14 meeting - in what would be its first such move in a year and second in nearly a decade - the worry for some stock investors is that the Fed takes a more aggressive stance on inflation and future hikes.

Stocks have set a string of record highs since the Nov. 8 election on hopes of a pickup in U.S. economic growth, thanks to President-elect Donald Trump's promises of increased infrastructure spending, lower taxes and easier regulations.

U.S. investors seem optimistic about prospects of future growth, but the question remains if the Fed does as well.

The U.S. central bank should announce new economic forecasts next week, along with a rate hike. If inflation is expected to pick up quickly, the Fed may need to raise rates faster than investors expect, and that could be a negative for U.S. stocks.

"If they believe that inflation is going to march higher and more rapidly ... That would give the market reason to pause," said Quincy Krosby, market strategist at Prudential Financial in Newark, New Jersey.

"I don't think investors want to hear that this is going to be an aggressive Fed."

Fed Chair Janet Yellen will more likely want to reassure investors that the transition to higher rates will be gradual, she said.

Traders work on the floor of the New York Stock Exchange (NYSE) in New York City, U.S., December 8, 2016.Brendan McDermid - RTSV9AD

Last December, the Fed raised rates for the first time in nearly a decade, and later signaled four more hikes would come in 2016. But the outlook quickly changed as the economy did not pick up speed, oil prices fell further and the stock market plunged at the start of 2016.

Next week, "the market is going to try to key off of whether we are going to fall into the one-to-two (hikes), or the three-to-four for 2017," said Jason Ware, chief investment officer at Albion Financial Group in Salt Lake City.

"If in the statement and the discussion afterwards it appears that the Fed is getting more concerned that they are behind the curve and they have to tighten more aggressively than the market currently expects, that could knock stocks back."

Given the sharp run-up in equities since the election, some strategists are already advising caution. The S&P 500 .SPX has had its best five-week run since March and the Dow is up 7.8 percent since the election.

"The market is now overbought in the short and long terms," said Brad Lamensdorf, a manager for the Ranger Equity Bear exchange-traded fund (HDGE.P), which bets stocks will fall.

Financials could see the biggest impact if there's a shift in the outlook for rates. The group has outperformed the broader market in the recent rally, partly on the view that Trump will ease regulations for the sector but also on expectations of rising rates, which benefit banks.

Stock investors also worry about the impact of rising rates on the U.S. dollar.

Strategists in a Reuters poll this week cited the dollar, which has strengthened sharply since the election, as among the biggest possible risks for stocks next year because of its negative impact on U.S. multinationals' earnings.

Reporting by Caroline Valetkevitch; Additional reporting by Lewis Krauskopf; Editing by Rodrigo Campos and Nick Zieminski

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