By Lewis Krauskopf
NEW YORK (Reuters) - An inflation report in the coming week will test the strength of the record-setting U.S. stocks rally and provide a crucial piece of data that could factor into the Federal Reserve's plans for rate cuts.
The S&P 500 on Friday was on pace for its third-straight weekly gain, pushing its year-to-date advance to over 27%.
The rosy backdrop for stocks is underscored by expectations of further Fed interest rate cuts at the same time the economy remains resilient.
That scenario historically has produced strong equity gains, and it was supported by Friday's employment report that monthly job growth was stronger than expected. Yet the data was not likely to signal a material shift in labor market conditions that would cause the Fed to rethink its rate trajectory at its Dec 17-18 meeting.
However, data on consumer prices due on Wednesday could threaten the upbeat narrative if inflation rates are above expectations, posing a challenge for high-flying stocks.
"If you come in hot, I do think that's going to be tough for the stock market to digest," said Matthew Miskin, co-chief investment strategist at John Hancock Investment Management. "It is going to bring in a little bit of uncertainty ahead of the Fed meeting."
Bets that the Fed would cut rates at its next meeting firmed after the November payrolls report. Data showed an increase of 227,000 jobs, but the unemployment rate ticked up to 4.2%.
Fed fund futures trading as of mid-day Friday indicated a nearly 90% chance the central bank would cut by 25 basis points, according to CME FedWatch.
Following the jobs data, there is a "higher bar" for the upcoming consumer price report to pause any planned rate cut at the Fed's next meeting, said Molly McGown, U.S. rates strategist at TD Securities.
The consumer price index is expected to have climbed 2.7% for the 12 months through November, according to Reuters data.
Rather than pause rate cuts, if CPI comes in hotter than estimates, the central bank could implement a "hawkish cut" by tempering expectations for reductions in 2025, Miskin said.
The potential for a revival in inflation is also in greater focus because of President-elect Donald Trump's plans to raise tariffs on imports. Tariffs are expected to be inflationary.
TD Securities expects the Fed to pause rate cuts at the start of the year, as policy makers assess Trump's fiscal policies after he takes office in January, McGown said.
"We heard from (Fed Chair Jerome) Powell that once they know what the actual policies are, that's when they'll start to put that into their framework of figuring out what they're going to do with monetary policy," McGown said.
Meanwhile, stocks continue to charge higher, raising concerns about sentiment becoming worrisomely optimistic. The S&P 500 was trading at 22.6 times expected earnings for the next 12 months, its highest P/E ratio in more than three years, according to LSEG Datastream.
Yardeni Research cited concerns with several measures, such as bullish sentiment among investment advisors and foreign private purchases of U.S. stocks.
"Contrarian indicators are turning bearish," Yardeni said in a note on Thursday.
Yet some investors say the prospects for stocks look solid into year end, which is a seasonally strong period for equities.
"The bear arguments from earlier in the year -- such as the job market pressures, interest rate fluctuations, Fed uncertainty, and geopolitical tensions -- have significantly eased," Mark Hackett, chief of investment research at Nationwide, said in emailed comments. "It is difficult to see how this trend reverses by year end."