Larry Kudlow asked the exact right question on his show last Friday night. Can stocks withstand an increase in the Fed Funds rate as Chairman Bernanke has implied he is willing to do. Generally two things can kill stock prices. A rising rate of inflation (which Stefan Abrams correctly and eloquently said is the worse thing for stock prices) and/or high or rising taxes on investment that causes multiples to decrease reflecting what will be lower after tax returns (and thanks to Steve Moore of the WSJ for spelling that out.). Before a more direct answer to Larry's question, a little groundwork needs to be set. (See Friday's debate in the accompanying video).
The two-year Treasury note is now yielding over 3% and the ten year is yielding around 4.25%. Yet the Fed Funds rate- the rate banks charge one another for overnight loans- is at 2%. The market has already priced itself higher knowing that a) inflation is more of a threat than a 2% FF rate implies, or, b) the economy is growing enough that higher rates are needed to allocate money properly, or both. To me the most critical issue facing us now is the weak dollar and the overwhelming need to strengthen it. A stronger dollar would lower the price of oil since oil is priced in dollars. For inflation to moderate, lower oil is an absolute requirement.