Will stock swoon delay a hike in interest rates?

Although Monday's bloodbath in stocks underlines the mounting concerns about slowing global economic growth, it also offers a stark reminder of another catalyst on investors' minds: The Federal Reserve may be about to raise interest rates.

The immediate cause of the wipeout was a lack of action over the weekend by the People's Bank of China to lower interest rates or take other steps to shore up sagging economic growth. Global investors are eager for Beijing to lend such monetary support as China's economic data worsens and stock indexes in the country continue to sink.

With the threat of a September rate hike from the Federal Reserve still on the table, traders stampeded for the exits.

The action reveals just how addicted markets have become on the flow of cheap money stimulus and the faith that it remains the path to economic deliverance. The problem: Both are at risk.

A recent research paper from the St. Louis Federal Reserve Bank finds that after six years of quantitative easing that swelled the Fed's balance sheet to $4.5 trillion, the policy "has been ineffective in increasing inflation" and only seems to have boosted stock prices.

In a note to clients, Deutsche Bank warned that "the fragility of this artificially manipulated financial system was exposed" and that "the only thing preventing another financial crisis has been extraordinary central bank liquidity and general interventions from the global authorities."

They highlight "the genesis of this recent sell-off has been the threat of the Fed raising rates next month, but China's confrontational move two weeks ago and the subsequent knock-on through [emerging markets] have accelerated us towards something more serious."

As a result, the financial firm put the odds of the Fed raising interest rates at its September 16-17 policy meeting at less than 5o percent.

Barclays Capital economists Michael Gapen and Rob Martin have pushed back their rate hike forecast to March 2016. They admit Fed policymakers are "market dependent" and won't tighten policy in the maw of a stock correction, while seeing "economic activity in the U.S. as solid and justifying modest rate hikes." Should the market turmoil continues, the rate hike could be pushed past March, they wrote in a note.

Alberto Gallo, head of credit research at RBS, sees the odds of a September liftoff at just 30 percent -- down from 36 percent last week -- based on futures market pricing. He thinks the Fed is more likely to act to raise rates in December. The breakdown in the dollar suggests currency traders are already pricing in a hike delay.

The open question: If the Fed delays its rate hike and the People's Bank of China move ease monetary policy, will stocks rebound?

We're about to find out.

Aggressive policy measures by Beijing over the last few months to stabilize Chinese shares have failed, eroding confidence in government efforts to stem losses. Meanwhile, after the May 2010 "flash crash," U.S. stocks initially rebounded before exceeding the panic lows in the months to come. The hit to sentiment from dramatic falls of the kind seen on Monday may take time to heal.

Heading into the close of trading on Monday, the Dow retreated back below the 16,000 level after Atlanta Federal Reserve Bank President Dennis Lockhart reiterated that the Fed is likely to start raising interest rates this year. It looks like the market needs to panic a little more to get a response from the Fed, especially if the August payrolls report on September 4 comes in strong.

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.