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Maybe Wall Street can handle a Fed rate hike

The Federal Reserve surprised no one when it didn't raise interest rates on Wednesday, given its lingering concerns about inflation as well as global economic and financial developments. Yet, Wall Street reacted with a surprising, powerful rally. And that raises interesting questions about how investor psychology may be shifting when it comes to how that inevitable rate hike will be viewed when it finally arrives.

It seems far more likely now that it will arrive in December. The Fed removed language from its policy statement about near-term pressures on inflation while adding a line about how it's monitoring the economic data to determine whether it will be appropriate to raise interest rates "at its next meeting."

The futures market responded by raising the odds of a December rate hike to 47 percent (from 39 percent before). Initially, that pushed stock prices down violently from their Wednesday morning highs into negative territory on what looked like the predictable response to the potential end of the Fed's zero-percent interest rate policy, which has been in force since 2008.

But then, just as hope began to fade, stock prices turned and zoomed higher. Even by the standards of normally volatile Fed announcement days, the reversal was impressive. And it seems to be driven by a realization that, despite months of tension, higher interest rates may not necessarily be such a bad thing.

In the end, the Dow Jones industrials index gained 1.1 percent, or 198 points, to move closer to the 18,000 benchmark last crossed in July.

Financial stocks were the big winners as expectations for an interest rate hike boosted long-term yields and thus, lifted net interest margins. The group gained 2.4 percent, with Citigroup (C) up 4 percent and Bank of America (BAC) up an impressive 5.4 percent. The same interest rate dynamic inversely hit yield-sensitive utility stocks, pushing the group down 1.1 percent.

The behavior of bank stocks reveals an important takeaway highlighted by the team at Capital Economics: A Fed hike, while potentially jarring since it hasn't happened since 2006, probably won't end the bull market.

For one, the start of the Fed's last three major policy tightening cycles didn't have a big negative impact on stocks.

Two, and to dip a toe into financial theory, Fed policy affects stocks indirectly via the impact on corporate earnings and the long-term interest rate at which investors discount those earnings into the future. This rate is divided into a "risk-free" component as well as components related to the risk of default, inflation, liquidity, etc. A modest pace of policy tightening will have complex and not necessarily negative impacts on this rate.

For instance, higher rates could have a dampening effect on, say, auto stocks like Ford (F) or homebuilders like Toll Brothers (TOL) as consumer credit gets more expensive, but they'll be a positive for bank earnings as the gap between loan rates and deposit rates widens.

Moreover, a small amount of monetary policy tightening could keep long-term interest rates lower by limiting the rise of inflation expectations.

Looking ahead, the flow of economic data and the takeaway from Fed speeches will only increase in importance now that the Fed has talked up the chances of a December rate hike. Capital Economics' Paul Ashworth still believes that the November and December payroll reports won't be strong enough to justify rate liftoff this year.

Societe Generale economist Aneta Markowska bumped up the odds of a December hike to 45 percent from 40 percent before. She noted the Fed softened its language on the labor market ("the pace of job gains slowed") but buffed its language on domestic demand despite disappointing retail sales and durable goods reports recently.

Michael Feroli at JPMorgan noted that the Fed's statement included the first explicit mention of possible action at its next policy meeting since 1999. In his words, "it's hard to see how the statement could have been more direct in flagging the risk of a December hike."

While the uncertainty still has many on edge, investors should be encouraged by Wall Street's ability to see the silver lining in the approaching end of the Fed's long experiment with near-zero interest rates.

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