Farrell: Raising Rates Would Spark a Rally

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.

The European Central Bank has implied it is going to raise rates which taken by itself would continue the flow of liquid assets to the euro and away from the dollar. There are enough signs of growing weakness in Europe that I think they will be forced to lower rates in the not too distant future. Between now and then, defending the dollar and lowering the price of oil would contain the rate of inflation.

I think stocks would rally if the Fed raised rates. Normally rising rates hurt stocks as fixed income investments take on additional attractiveness with higher yields. But these are not normal times. Stocks would not only withstand a rise in the Fed Funds rate, they would embrace the move and rally.

The timing of such a move was debated. Doug Kass, my granddaughters honorary uncle (a unique and special position if there ever was one), thinks the Fed should wait till after the election to avoid the appearance of being politicized. Dougie also added the thought that higher rates hurt the already depressed housing industry. An additional thought is the Fed should wait till the rebates are fully distributed and accounted for. All good points. If the decision was mine, I would raise rates a quarter of a point like yesterday. The market has already raised its rates, the ECB is threatening to raise rates, and we have a nice, though small, dollar rally underway in anticipation the Fed is on the problem. I think the benefits of a stronger dollar and weaker oil far outweigh the negatives and the stock market would love it. Ben, take back just a little bit of the loose money of the past months.

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Vincent Farrell, Jr. is a Principal of Scotsman Capital Management and a regular contributor CNBC.