Higher interest rates will not be bad for stocks

Many observers and investors worry that stocks are going to be hit when the Fed starts to raise interest rates, especially if they move too soon to tighten. I've maintained for a long time, in contrast, that an early tightening of monetary policy would be good for stocks. This chart shows that investors' fears are not necessarily well-founded.

The ECB last week surprised the world by moving sooner than expected to lift its short-term interest rate target. I wrote last week that this was a good thing, and noted that pre-emptive monetary policy tightenings have been very good for the euro, the Aussie dollar, and the Canadian dollar.

The chart above extends that observation to the stock market. German 2-yr yields, which are the market's best guess for what the ECB's target rate will average over the next 2 years, have soared from a low of just under 50 bps in June, 2010, to now almost 190 bps. This move was driven by the ECB's sooner-than-expected tightening of monetary policy, and the rise in rates closely parallels the new-found strength of the European stock market.

This is not surprising, of course, since a central bank's moves are almost always a complicated dance between the market's perception of the economy's strength, and the central bank's perception of that same strength. Sometimes the market signals the central bank that a move is Ok, and sometimes the central bank guides the market. In recent months the European economy is looking better, the central bank is more concerned that inflation might be picking up, and the market is happy that the ECB is not going to slip behind the inflation curve without a fight.

I would anticipate, therefore, that an earlier-than-expected tightening move by the Fed would be greeted with similar enthusiasm. Tighter policy would acknowledge that the economy is in better shape, and at the same time reassure markets that the Fed is anxious to stay on top of things, rather than fall further behind the inflation curve. Confidence in the future, and confidence in one's currency, are very important sources of support for equity prices.