An interesting correlation was seen in the markets yesterday. With the Federal Reserve coming out with hawkish sentiment for a rate increase this month (now over 80% likely), the markets rallied. In the past this was a good reason for the markets to sell off, re-valuing equities to higher discount rates. Now the opposite has occurred and it is tough to understand what to think of rate increases going forward. The best way to make sense of this seemingly reversed trend is to look at where the markets feel the Fed is in terms of combating inflation.
In the past the Fed has been reluctant to increase rates at the cost of the fragile recovery. This caused one rate increase per year over the last two because of concerns with brexit, elections and a lack of inflation. This put the market in the mindset that the Fed would like to see a very strong sign on recovery before taking action on inflation alone. During the end of last year inflation creeped up and now the Fed is changing it tune to raising rates despite Trumps tax and regulation plans. In the near term this expresses that the Fed seems to be a bit behind the curve, due to their caution, and have pushed up their rate hike to this month. This gives the market a signal that the Fed feels things are better than their previous expectations. If the Fed looks to try and correct this mistake with taking action with less external factors in consideration, the market could perceive future rate hikes differently in the future.
Should the Fed start to look at inflation rates alone and not worry as much about political and market turbulence in their decisions, the pace of rate increases could become less accommodating to markets. This drive to get ahead of inflation could lead to rate increases while the markets stagnate and bond becoming more attractive with an introduction of volatility.
That isn't to say that a rate hike is going to reverse the post-election rally, but it will certainly start to move independently of market expectations and could travel a path not aligned with high stock valuations. At a minimum it will make alternatives to stocks a more attractive prospect in the future.