Stock Market Rally Should Continue After Fed Tightens

Here are two reasons the stock market should continue to rally after the Fed hikes the funds rate by 25 BPs at the June 13-14 FOMC Meeting.  First, stocks should view it as indicative of Fed confidence that the rate hike will not deter moderate economic growth ahead.   Second, stocks, as well as other markets, should move in directions that work to achieve the Fed's goal of sustained moderate growth -- an "optimal control" approach to understanding markets.

The May FOMC Minutes show Fed staff more confident of above-trend economic growth over the next few years -- even with additional monetary policy tightening.  The Minutes said "Beyond the near term, the forecast for real GDP growth was a little stronger, on net, than in the previous projection, mostly due to the effect of a somewhat lower assumed path for the exchange value of the dollar. The staff continued to project that real GDP would expand at a modestly faster pace than potential output in 2017 through 2019, supported in part by the staff’s maintained assumption that fiscal policy would become more expansionary in the coming years." This improved outlook possibly could show up in the updated Central Tendencies released at the June meeting, although the Central Tendencies reflect a composite of the District Fed forecasts and not the Board staff's forecast.

The "optimal control" approach to understanding markets is based on the idea that the major markets -- stocks, bonds and foreign exchange -- move in directions that work to achieve the Fed's goals.   With the Fed wanting to raise the level of the Fed funds rate to its longer-term equilibrium level, the tighter short-end of the Treasury yield curve works against its other goals of sustaining moderate economic growth and lifting inflation.  So, the long-end of the Treasury curve, stocks and dollar will work to offset this tightening -- stocks should climb, while long-term yields and the dollar should fall.   To be sure, since there are more "controllers" than targets, not all the markets will necessarily move in the right direction.  But, if one market moves in the wrong direction, the other markets would have to work harder to achieve the Fed's targets.  At the moment, the three major markets are moving consistently with the growth/inflation targets -- stocks are up, while longer-term yields and dollar are down.  (This combination has perplexed many market commentators, who, based on conventional theory, expect these markets to move the opposite way in the face of a Fed tightening.)  With the Fed likely to hike 2-3 times more this year (in June, September and December), these markets have room to move further in the "right" directions, according to an optimal control approach.

The Fed is likely to lift the funds rate by 25 BPs in June, even though forecasts of Q217 Real GDP Growth have come down after the latest batch of data.  The Atlanta Fed and NY Fed models now project 3.6% and 2.1%, respectively (was 4.1% and 2.2%), after April data showed a widening in the trade deficit and soft inventory investment, while Q117 Real GDP was revised up to 1.2% from 0.7% (the latter in part a result of a smaller drag from one-off consumption weakness that implies a smaller rebound in Q217).  The lower forecasts, however, still are above the 1.5% long-term trend. 

The latest Unemployment Claims fell further in May, providing evidence that above-trend economic growth and the tightening trend in the labor market are being sustained into the Spring.

                               Initial Claims (level, 000s)
       May Avg to Date                  234
       Apr Avg                                241
       Q117 Avg                             243
       Q416 Avg                             256

This week's key data should not deter a June Fed rate hike, despite soft inflation prints.  Although April Total and Core PCE Deflator are expected to show a slowdown on a y/y basis, Fed officials could dismiss it -- based on the May FOMC  Minutes.  The Minutes said, "Core PCE price inflation, which historically has been a good predictor of future headline inflation, moved down to 1.6 percent over the 12 months ending in March.  However, it was noted that some of this slowing reflected idiosyncratic factors such as a large drop in the measure of quality-adjusted prices for wireless telephone services."  Downplaying the drop in wireless telephone services is debatable, since the introduction of unlimited phone plans suggests excess capacity that may persist.  But, its downplaying shows Fed officials are not yet willing to trend out the idea of slower inflation ahead.  Note that the dovish Fed Governor Brainard speaks again on Tuesday, so she'll have a chance to weigh in on low inflation if she wants.

This week's real-side data should argue for a rate hike.  Evidence on the May Mfg ISM is mixed, with Phil Fed Index up but Richmond Fed Index down.  Whatever prints, the level of the Mfg ISM should be decent.  The May Employment Report should show a decent gain in Payrolls, but perhaps not as strong as the +179k consensus, and a steady to lower Unemployment Rate.  But, Average Hourly Earnings should be soft and weaker than the 0.2% m/m consensus.  Calendar considerations suggest 0.1% m/m (2.4% y/y versus 2.5% in April).