WSJ: When Interest Rates Rise, Watch Out

http://online.wsj.com/article/SB10001424127887324048904578318372831147906.html

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.