Andy Kessler: When Interest Rates Rise, Watch Out; The Fed’s inevitable Sword of Damocles could be brutal for bonds and stocks. Some of us recall the massacre of 1994

February 21, 2013, 7:09 p.m. ET

Andy Kessler: When Interest Rates Rise, Watch Out

The Fed’s inevitable Sword of Damocles could be brutal for bonds and stocks. Some of us recall the massacre of 1994.

By ANDY KESSLER

Can Ben Bernanke fly us through a needle’s eye? Minutes released this week from the last Federal Reserve policy meeting suggest evaluations are taking place that “might well lead the Committee to taper or end its purchases before it judged that a substantial improvement in the outlook for the labor market had occurred.” It’s about time. The experiment to kick-start the economy with near-zero interest rates has failed. Maybe our central bankers have figured out that low rates are what is holding back lending and hiring and growth.

Meanwhile, even as the stock market hits highs not seen since 2007, everyone on Wall Street knows interest rates will go up—although no one except Mr. Bernanke knows when. Investors are playing a game of chicken with rates, enjoying the ride but bracing for a downturn when the rates turn up. When rates go up, bonds become more attractive than stocks because you get returns with less risk.

Those of us on Wall Street in 1994 witnessed something very similar. After several years of essentially flat short-term rates, the Fed raised rates by 25 basis points (or 0.25%) on Feb. 4, 1994. The Fed raised short-term rates a total of six times and 2.5% over the next 10 months.

In what became known as a bond-market massacre, the price of long bonds dropped almost 9%. The stock market dropped 9% in three months, killing a then-vibrant market for initial public offerings.

Today we are at the bitter end of a three-decade-long interest rate cycle, culminating in Mr. Bernanke’s near-zero rates. You can’t fall off the floor. And the prospect of higher interest rates is like the Sword of Damocles hanging over the stock market.

Balance in Business

On May 13, 1981, the three-month Treasury bill rate was 17.01% and the Dow Industrials were just under 1000. Today, three-month rates are under 0.12% and the Dow is headed south from 14000. What should interest rates be? In January, the Consumer Price Index rose 1.6% year over year. In a normal economy with a normal Fed, short rates should be 2%-3%.

Investors beware: The unwind is going to be bumpy. The entire U.S. bond market is over $30 trillion. Any sudden increase in interest rates means current holdings would be worth less and might create turmoil from runs or even “breaking the buck” at money-market funds. Gold is already down over 15% from last year’s October peak, anticipating this Fed move.

All along, Mr. Bernanke’s intent was to allow banks to recapitalize despite all the toxic mortgage debt that he and Treasury Secretary Timothy Geithner left on their balance sheets, so we’ve lived with almost four years of sub-0.2% interest rates. The results of the latest bank stress tests are due out on March 7, but 15 of the 19 largest banks (Citigroup C -2.01% the glaring exception) passed the last one. The justification for low interest rates is no longer to save banks, but instead to goose the stock market as an indirect way to create jobs.

Mr. Bernanke told CNBC last year that, “Our policies have contributed to a stronger stock market just as they did in March 2009 when we did the first iteration of this program.” No kidding. But as a policy tool, low interest rates are like using gasoline to light your charcoal grill. You may singe your eyebrows, but it will certainly light the coals. The question is will the coals stay lit when the gasoline burns off.

When rates rise, the bond market will sell off, but foreign investors seeking a safe haven from their messes may continue to pile in and limit the damage, especially if incoming Treasury Secretary Jack Lew implements rather than jawbones a strong dollar policy.

The stock market is another thing. Every day this trading venue captures collective expectations in prices—expectations of corporate profits and interest rates and risk. Stocks are nothing more than all the future earnings of a company discounted back to today. The discount rate is a combination of prevailing interest rates plus some factor of risk.

But there is no risk or discount number published anywhere. It’s touchy-feely. Expectations change daily. That is why stocks are said to climb a wall of worry. When no one is worried, you run out of buyers and markets top. When everyone thought Apple’s share price was going to hit $1,000, and every hedge fund owned it, of course it sold off as all that good sentiment was in the stock.

But there is one real market absolute: interest rates. Right now, mutual- and hedge-fund managers are scrambling their brains trying to figure out when rates will rise, trying to outguess the Fed, other investors and probably themselves. The economy dropped a tenth of a point last quarter, Spain and Portugal are still a mess, only 157,000 jobs were created in the U.S. in January, tax rates are popping and corporate earnings may grow only 1%-2% this year.

But if and as these worries ease, the Fed’s Sword of Damocles will swing. The stock market is not going to like it one bit. But why should the Fed care? Banks are recapitalized and the charcoals are lit. Our central bankers should be agnostic to stock prices anyway. This doesn’t mean the stock market is going to crash, though dropping 1,000 points in a few weeks would not be surprising.

There is a possibility that Mr. Bernanke will thread the needle and manage to gradually raise rates, grow the economy and keep the stock-market rally intact. Investors should be rooting for him. The Fed, when it does move, is going to be slow and steady. Dallas Fed President Richard Fisher told Bloomberg radio recently, “I don’t want to go from wild turkey to cold turkey.”

Rising rates are OK as long as corporate profits and the dollar are rising faster, especially if declining energy and food prices provide a boost. If I were Mr. Bernanke, I wouldn’t wait. Tomorrow morning I’d start raising rates as a signal to all that the economy is on sound footing.

Announce loud and clear that you are going to raise the federal-funds rate 10 basis points (or 0.1%) every month, like clockwork, until it exceeds the inflation rate, and then declare victory. The stock market might even rally on the certainty and return to normalcy.

Rising rates are inevitable. But be advised that in selloffs, stocks fall into the valley of despair. The 1995-2000 bull run followed the bond-market massacre.

Mr. Kessler, a former hedge-fund manager, is the author most recently of “Eat People” (Portfolio, 2011).