Should Markets React to a June Fed Rate Hike?

Here are a couple of thoughts on how the markets may react to a June Fed hike -- if it happens.  First, overall financial conditions should be little changed, since a 25 BP rate hike already is embodied in the Fed's forward guidance and thus in the markets.  Second, while financial conditions are likely to be little changed, their composition could change.   Analyzing the markets using optimal control concepts shows how.

Fed's Forward Guidance
I have argued that the Fed's forward guidance is more important than the actual hike in rates, as the latter already is embodied in the earlier guidance.

So, while most market analysts thought the Fed's 25 BP hike in December 2015 was modest, in fact the further 100 BP hike in the Fed's "dots" for 2016 made the tightening much greater than the actual rate hike -- and helps to explain why financial conditions collapsed in the face of an ostensible modest hike.  Similarly, while most market analysts said the Fed kept monetary policy steady in March 2016, in fact they eased by 50 BPs as a result of skipping March and lowering the 2016 forward guidance by another 25 BPs  -- both viewed relative to the earlier forward guidance.  This easing helps explain the April stock market rally and dollar weakening.

Thus, a 25 BP hike in June -- with no change in the forward guidance -- would be in line with the prior forward guidance and comprise no change in policy.  And, financial conditions should not change much after the hike.

Optimal Control Concepts
The markets can be interpreted using optimal control concepts by postulating that on balance they move in ways to achieve the Fed's targets.  The Fed wants economic growth to continue around 2.0% and for inflation to move up t0 2.0%.  So, according to optimal control concepts, the markets should be net stimulative after a Fed rate hike in order to offset the greater restrictiveness of the short-end of the yield curve.   Currently, the Fed tightening is not aimed at slowing the economy or pulling down inflation, but to bring the funds rate to a "normal" level.  The markets have to move in ways to sustain the economy -- unlike past episodes of Fed tightening which were meant to slow the economy.

For example, if the dollar rises further in response to a Fed hike, stocks would need to rally to offset the drag from net exports.  But, a decline in commodity prices, particularly oil, would be stimulative of consumption and thus reduce the "need" for stocks to rally.   Moreover, a rally in the long-end of the yield curve -- helped by the stronger dollar and lower commodity prices -- also would reduce this need.   It is conceivable that stocks overall would be little changed after a Fed rate hike, although the sectoral reaction would not likely be uniform.