A rate hike in September is unlikely but why are markets so jittery?

Last Monday, Stanley Fisher who is the Vice Chair of the Federal Open Market Committee (FOMC) suggested that more time is needed before a rate hike can take place. If this is coming from a senior policy maker, it pretty much sums up that a rate hike will not be a done deal next month.

In addition, another member of the FOMC, Narayana Kocherlakota mentioned in his opinion piece in the Wall Street Journal yesterday that "raising US rates now would be a mistake." He argues mostly on the basis that the inflation rate is too low. For the past 3 years, the inflation target has been missed continuously. With inflation so low, higher interest rates will push real interest rates higher. Real interest rates are interest rates net of inflation. This in turn would discourage people from borrowing money and increasing the dollar`s value even further.

The Federal Reserve is mandated by Congress to promote price stability and maximum employment but only the latter has been achieved so far. Therefore, the FOMC should loosen its policy instead. Narayana Kocherlakota brilliantly ends his article by stating that "when the public comes to doube a central bank`s commitment to its goals, the economy could land in a permanent low interest rate trap. Consequently, central banks would be less effective in fighting recessions. (Think Japan)

Now, what if rates do increase, regardless of whether it is next month or by end of 2015? An economic disaster is set to happen based where emerging markets stand to lose the most.

Two main players are to be blamed, the strength of the greenback and the simultaneous devaluation of the yuan. Since the 07-8 crisis, China has been enjoying an unsustainable growth boosted by a massive amount of debt. No other emerging market has taken on debt as the same pace as China according to Morgan Stanley`s Ruchir Sharma.

So, why are other emerging markets suffering? Emerging markets are facing a hard time as they have jumped onto the bandwagon on China`s boom. These investments are mostly funded by cheap creditfrom the US. Now, as the US economy is recovering and China`s economy is slowing down sharply, the currencies are going in opposite direction. Imagine taking a loan in USD a few years back due to the low interest rates and then investing it in China. Well, everything was fine until now.
Now, picture having to payback the loan in yuan terms when the dollar is rising, yuan dropping and the risk of an interest rate hike in the very near future that interest rates would be hiked and increasing the gap between these two currencies. A disaster, no?

Now, let`s scale this up a bit to see how severe the situation is. Corporate borrowers in the developing world have borrowed $1.3 trillion in dollar denominated bonds since 2010. The biggest borrowers are China, Brazil, Russia, Mexico and South Korea. A change in interest rates (and exchange rate) no matter how small it may seem would be a catastrophe.

The FOMC must consider all stakeholders in its rate hike decision. A moral hazard is about to take place and the next recession is set to start in China.