Key Points

• The market anticipates an 87% chance of a 25-basis-point interest-rate cut by the Federal Reserve after its Dec. 9-10 meeting.

• The S&P 500 gained 0.3% in the week ending Dec. 5, placing it within 0.3% of its record close.

• Investors are focused on the Fed’s 2026 monetary-policy projections, particularly regarding additional rate cuts, to gauge the potential for a “Santa Claus rally.”

December tends to be a strong month for stocks - so much so that investors have come up with the term "Santa Claus rally" to describe the gains that stocks historically see at the end of the year and into the start of the new year.

But before Santa Claus comes to town, there's a market-moving event that could determine whether investors will get new all-time highs or coal for Christmas. That event is the Federal Reserve's policy meeting on Dec. 9-10, where the central bank's Federal Open Market Committee will determine whether to adjust its benchmark interest rate.

"The key question hanging over markets is whether a potential Federal Reserve rate cut next week can trigger a so-called Santa rally," Fawad Razaqzada, market analyst at StoneX, wrote in a note. "For now, the S&P 500 forecast remains cautiously constructive, albeit with more hesitancy creeping in."

Currently, the market seems pretty convinced that the Fed will cut interest rates at its December meeting. 30-day fed-funds futures are pricing in around a 87% chance of a 25-basis-point cut, according to the CME FedWatch Tool.

That optimism for a rate cut has seemed to be propelling markets lately. Stocks saw a few weeks of selling in November, with the S&P 500 SPX falling as much as 5.1% from its closing high on Oct. 28 to its Nov. 20 low. But the index rebounded during the shortened trading week of Thanksgiving, and gained another 0.3% the week ending Dec. 5, putting it within 0.3% of that record close.

According to Dave Grecsek, managing director of investment strategy and research at Aspiriant, the November selling was the product of two things: concerns about the effects of an extended U.S. government shutdown, and doubts around the artificial-intelligence trade.

A certain level of doubt surrounding what's been one of the market's hottest trades of the past few years is a healthy thing, Grecsek noted. On top of that, the government shutdown is now over, calming some of investors' worst fears and restarting the flow of official economic data. That economic data has helped propel the argument to cut rates, which in turn has helped markets.

Read: Inflation didn't get any worse before government shutdown. Fed seen cutting rates again.

"On the labor-market side, the data there is a little more supportive for the Fed to cut again here in December," Grecsek told MarketWatch. "There was a time coming into September and October where the December rate cut was kind of off the table. And now all of a sudden, in the last part of November, it's really back on the table, and I think that's what's driving markets."

But the bigger deal, according to Grecsek, is not the December rate cut - which markets seemed to have already priced in - but additional cuts next year. He said that investors are anticipating another two to four cuts in 2026, depending on who you ask. Those additional cuts are what could really drive markets higher and kick off the Santa Claus rally.

So, going into the December FOMC meeting, investors will likely be paying attention to any clues about monetary policy in 2026. In addition to a rate decision, the Fed will also release its Summary of Economic Projections, which it releases four times a year and which offers projections on factors like the expected unemployment rate, inflation and interest rates in the future.

"I think it's going to come down to more of what the Fed is looking at with their projections for 2026. That's going to give us the idea of whether we can have this Santa Claus rally at the end of the month," Bret Kenwell, U.S. investment analyst at eToro, told MarketWatch. "We're going to have a good idea of where the Fed is standing and what they expect for next year, and I think that'll set the tone."

It's impossible to know for certain what the Fed will say in this regard, which is why markets have yet to price this in. Investors will likely adjust their expectations for future rate cuts based on these projections, Kenwell said, but if they expect two cuts in 2026 and the Fed projects only one, the 25-basis-point difference could mean the adjustment won't be too drastic.

But if Powell casts doubt on future rate cuts in commentary during his press conference, that could throw some cold water on a December rally even if the Fed cuts rates - just like what happened after the December FOMC meeting last year.

Another thing to keep in mind is that Powell's term as Fed chair ends in May, and President Donald Trump has said he's likely to pick a Fed chair soon who will be willing to bring rates down.

"Looking at the next chairman as being likely more dovish than Powell, that could be enough to keep the holiday rally alive," Kenwell said.

Investor positioning ahead of the Fed meeting

Even if the market expects a rate cut, that doesn't guarantee how stocks will react on the day of the Fed meeting.

Options traders are pricing in a 1.3% swing in the S&P 500 on Wednesday, based on the premiums tied to options contracts expiring on Dec. 10. According to BNP Paribas, that's the largest implied move expected through the end of the year.

Read: Why options traders think Dec. 10 will be the most important day for markets before the end of 2025

"Looking ahead, I think we can expect a lot of volatility. I can easily see [the Nasdaq Composite COMP] going up another 5% to 10% the next few weeks, or going the other way," said George Kailas, chief executive of Prospero.ai. "But I think what everybody should take seriously right now is the volatility."

Prospero.ai uses AI to read institutional trading data and options sentiment, turning it into market signals for retail investors to interpret. Before Prospero, Kailas worked at a hedge fund and had experience trading on his own.

Kailas told MarketWatch that he anticipates a lot of volatility across the major indexes going into the next few weeks. He pointed out that the government shutdown meant that institutional investors weren't getting official data reports from government entities, which affected the trading models that they used. As a result, institutional investors were reacting to market moves in real time, he said. Kailas noted the initial market reaction the day after Nvidia (NVDA) reported earnings, and the subsequent reversal, as an example of this.

That dynamic could continue through the coming Fed meeting. Some traders are wondering if the Fed meeting could see similar "buy the rumor, sell the news" action like what happened with Nvidia.

Kailas said his models tell him that sentiment is more bullish than bearish, but he doesn't want to underestimate short-term volatility. His message to traders is: "Don't get too comfortable."

"Get used to, on some of these hard days, selling out a little bit of your positions. I think people look at it like it's an all-or-nothing proposition," Kailas said. "There's too many people that don't have that in their tool kit."

As investors gear up for a potentially volatile reaction to the Fed meeting, traders trying to time market moves may get tossed around. But taking a step back, eToro's Kenwell said the prospect of the Fed continuing to cut rates, along with no immediate existential threats to the economy, could help investors who are more long-term bullish.

"From a short-term standpoint, you might have volatility around those days without the Fed playing to the bull's desires. But long term, there's still the wind in their sails," Kenwell said.

While the Fed meeting is the main event of the week, investors will also get data on October's job openings on Tuesday and initial jobless claims on Thursday, giving them a clearer view of the labor market.