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Who's Afraid of the Fed? Market Actually Wants Rate Hikes

Forget the cosmetic move of raising the discount rate—the day the Federal Reserve really decides to start putting the brakes on growth could actually be a happy occasion for the stock market.

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Raising interest rates and stemming the flow of liquidity to the economy might otherwise be considered a barrier for stock market growth, but many investors are in fact eagerly anticipating that the move will add another level to investor confidence.

Though the Fed on Thursday announced a surprise hike in the discount rate that it charges banks to borrow money, the central bank continues to indicate that its more significant funds rate will stay near zero for the foreseeable future.

"Most people assume that the day the Fed starts tightening, the market goes down. That might be the short-term reaction," says Uri Landesman, head of global growth strategies for ING Investment Management. "I'm going to be happy because it's going to suggest to me that things are starting to get better."

Investors initially recoiled at the Fed decision, sending stock futures down overnight. But the market turned around Friday as the day progressed and banks actually were among the best gainers on the Standard & Poor's 500.

As long as the Fed does not rush its moves, the market seems perfectly content to watch rates drift higher.

"Long-term US interest rates rising moderately and slowly from today's extremely low levels as the recovery continues would be positive for stocks," David Bianco, chief economist at Bank of America-Merrill Lynch Global Research, said in a research note. "But sharply higher interest rates ... would be negative. An interest rate surge would destabilize the fragile recovery in US real estate and pressure the banks again."

Faced with high unemployment and a still-weak housing market, the central bank is walking a tightrope between ensuring economic growth and bracing against an inevitable wave of inflationary pressures from the low interest rate climate.

Timing will be everything.

Should the Fed wait too long to raise rates, it risks that prices, particularly in commodities, will spiral out of control. Conversely, if it tightens too soon it could choke off the monetary oxygen needed to resuscitate the wobbly economy.

"Investors would love to see normalized rates as an indicator that we've beaten deflation," says Quincy Krosby, general market strategist for Prudential Financial in Newark, N.J. "However, life gets in the way of what the Fed would like to do."

The Fed has other weapons at its disposal to direct monetary policy, and minutes released from its most recent meeting, as well as the quarter-point raise in the discount rate, indicated pressure to start pulling away some of the quantitative easing measures it implemented during the depths of the financial crisis.

But the Fed funds rate is the metric that garners the most notice and generates the greatest discussion among investors.

"You have to distinguish between the Fed removing the proverbial punchbowl versus taking the economy off of life support," says Jordan Kimmel, market strategist for National Securities in New York. "I would view (a rate cut) as a significant positive. When the rates go up, they'll probably go up faster than most people anticipate. Interestingly, I do not believe it will derail the market or the economy the way a lot of people are fearing."

There is a wide disparity of thought over when the Fed might make a move on the funds rate.

Opinions range all the way from Kimmel's projection of a hike in two or three months to BofA-Merrill on Thursday reaffirming its forecast that an increase will not happen before 2011

There even was some disappointment on trading floors with the message the Fed telegraphed Wednesday of being in no hurry for a rate hike.

"Unfortunately, we probably won't see any major rate change soon," Ben Lichtenstein of TradersAudio.com, told CNBC. "If we see a rate change it's a sign of strength. The Fed always sees things ahead of John Q. Public. I think that would show a sign ... of stability, and I think that would be a very positive thing."

Two principal issues are weighing against the Fed: high unemployment and the inability of the housing market to get off the floor even as many analysts think it has bottomed.

Landesman doubts the Fed will move on the funds rate—which is a greater determining factor in consumer lending rates—as long as unemployment stays above 9 percent, while Krosby sees housing as the larger priority.

"The market would start getting way ahead of itself with rate increases—that's what bothers the Fed. In essence the housing market, such as it is, would stall," Krosby says. "I don't see the Fed moving until they have a sense that the housing market is gaining some traction."

But Kimmel believes rising commodity prices due to a weak dollar might force the Fed's hand. Likewise, Landesman says raising rates will boost the dollar and restore the positive correlation between the US currency and stocks, something that has largely been missing during the market rally the past 11 months.

"There's no reason for life support," Kimmel says. "The signs of an economy recovery are already showing up in several different areas."

Ultimately, market pressures and not merely a desire to direct equity or commodity prices will determine the Fed's hand.

"The market is watching the data, examining the data, just as the Fed is watching the exact same data," Krosby says. "When the market feels we have entered a period of sustainable growth, that there is a virtuous cycle entrenched in the economy, the market will applaud the Fed's exit."