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Kass: Three Reasons Rising Rates Could Crush Stocks

He's no longer short the market, but that doesn't mean Doug Kass sees smooth sailing ahead.

The president of Seabreeze Partners Management has long warned that stocks were set to suffer a correction. He recently foresaw the S&P 500 breaking below 1,595 to swiftly hit 1,560. Now that Kass has seen the requisite move, he has shifted his net positioning from short to neutral, and predicts a range-bound market over the next several months.

But Kass is still worried that the market could encounter massive downside—and that most are unprepared for it.

"My greatest concern," Kass told CNBC's "Futures Now" on Tuesday "is that there is almost a universal view that stocks have limited risk from here."

But for Kass, that is far from the case, because of the massive spike in interest rates the market has already seen—and which is widely expected to continue.

(Watch: Top Technician: Yields Have 'Much Further' to Go)

"It is unclear to me how the U.S. economy is going to handle a rise in rates," Kass said. He then outlined three reasons why higher rates could pose a major problem to the economy and the stock market.

Douglas Kass at the Reach poker tournament in New York.
Amanda Gordon | Bloomberg | Getty Images
Douglas Kass at the Reach poker tournament in New York.

Reason One: Higher Rates Could Crush Housing

Kass worries that the housing rally has largely been built on the back of ultra-low interest rates—and he already sees some signs warning him that the rally is ending.

"I will tell you that refinancings, which buoy cash flows, have rolled over dramatically," Kass said. "There have been thousands of layoffs in refi departments in major banks."

Reason Two: Higher Rates Could Hurt Profit Margins

"Will higher profit margins be maintained if rates start to head higher?" Kass asked rhetorically.

Low interest rates can improve a company's profit margin in two major ways. First, they make it cheaper for a company to borrow money, thereby reducing an expense that weighs on margins. And second, lower rates hopefully foster sales by improving the economy.

"Remember that lower rates were an important driver in pushing margins to record highs," Kass said.

Reason Three: Liquidity Could Dry Up

Low interest rates tend to heighten the enthusiasm for the debt of companies with less-than-stellar credit ratings. After all, bonds that are considered riskier become the only place for fixed-income investors to turn in order to find decent yield.

Because rising rates will undoubtedly reduce investor interest in these bonds—indeed the iShares High Yield Corporate Bond ETF has already dropped by 3 percent in little more than a week—Kass worries that a "liquidity crisis" could be coming.

(Read More: Junk Bonds Suddenly Don't Look So Good Anymore)

The worst-case scenario, Kass said, is that "poorly rated companies" could "lose access to the capital markets just when they most need it."

These crises could feed upon each other, potentially driving the market much lower. But in the meantime, Kass waits on the sidelines of the market, watching carefully for his chance to buy or get short again.

— By CNBC's Alex Rosenberg. Follow him on Twitter: @C NBCAlex.

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