By Kathleen Brooks, Research Director UK EMEA FOREX.com

The markets are still in carnage mode post the FOMC. The worst of the damage has been in emerging markets, but the yen surge looks like it is out of steam, likewise, Treasury yields look poised to move higher. The interesting thing about last night was that the Fed seems to have ditched its softly, softly approach to the end of QE3. Last night was about coming clean to the market and laying it out as it is: tapering will happen later this year if economic growth stays at its current pace, and, shock horror, interest rates will eventually have to rise.

Bernanke's note to investors: time to think for yourselves

This may not seem like a dramatic shift from the Fed, and a lot of economists seem to think there is a huge overreaction from markets. I could not disagree more. For most of the last 5 years investors haven't had to think too hard about where to invest: yields are low in the West so search out higher yielding assets in emerging markets. Now they actually have to make investment decisions that some of them will have spent vast amounts of money at business school preparing for. They need to scrutinise balance sheets and search out quality assets, they also need to decide if they should trust the Fed and the US economic recovery and start looking at the US as an investment destination.

US Treasury yields and the crucial 2.5% level

There are a couple of things to watch out for: US 10-year Treasury yields are approaching a key psychological level of 2.5%, which is only 13 basis points away. If we get above here it could accelerate some of the bearish trends we have already seen such as the selloff in emerging market equity and bond markets, a selloff in European peripheral bond markets and in western equity markets. Is it surprising that the US markets have been better protected than elsewhere in the developed world? Not really, in this environment the FTSE 100 is extremely vulnerable due to its hefty commodity and mining sector. The FTSE 100 is down nearly 10% since mid-May, and losses have accelerated in the last 24 hours, which opens the way to a test of 6,000. Likewise, stock markets in Italy and Spain are down 11% and 9% respectively. A surge above2.5% in Treasury yields could exacerbate these moves, so watch the bond market closely.

Indian Rupee: partly the Fed's fault, partly its own fault

Emerging markets are very much in focus today. After sharp sell offs in EM FX markets the prospect of official intervention is back on the table. The Indian Rupee is one of the biggest victims of the change in Federal Reserve policy because Federal Reserve quantitative easing has led to large investment inflows into India in recent years, which has helped to prop up growth and development. When stimulus is coming to an end, some of that money is getting pulled out of the country, which causes investors to lose confidence in India's future growth prospects. But India hasn't helped itself in recent years. A poor record on economic reform and dysfunctional domestic politics has led to India having some of the worst economic fundamentals in the emerging world, so these investment outflows only make things worse for India. The Rupee is central to India's macroeconomic stability: it is vitally important for India's trade position and a falling rupee can cause a large increase in inflation, which threatens social stability. Thus, volatility in the rupee can have far reaching economic and social consequences. The central bank can try to stabilise the currency, but this costs money so it leaves the Rupee at the mercy of market sentiment. However, we think the Bank will intervene if the rupee weakens past 60.00 per dollar. Usually when the economy is under threat the central bank can cut interest rates, however if it cuts rates the rupee could fall further, so the central bank's hands are tied...

Norges bank policy is negative for the Nokkie

Elsewhere, the Nokkie is also making some big moves after a dovish Norges Bank. USDNOK surged above 6.00 earlier; even though the Norges bank kept rates on hold, the prospect of further rate cuts are very much on the cards. It appears that relative monetary stances in the US and Norway is the key driver of USDNOK for the medium term.

China ? not having a Lehman-like meltdown, yet

The other thing I have to touch on is China. Is it having a Lehman-like meltdown? Its inter-bank lending rates rose to a record on Thursday and the PBOC, unusually, did not step in with an injection of liquidity. The central bank has even come out and said that the cash-squeeze is being caused by its lack of action in the market, so why is it inflicting pain on its banks? A policy of inaction could be designed to punish excessively risky banks and cause them to fail thus flushing out the weakest links in the banking system; this is not a bad strategy, but a very brave one when markets sentiment is this fragile. It could also be a way to limit credit growth, which is running at an unsustainable 22-23% so far this year. So is this Lehman-like? Leverage in the Chinese banking system is fairly low, with a loan-to-deposit ratio of 70%, significantly lower than Europe where it is more than 100%. This means that banks have the capital buffers to withstand under-performing loan losses, and if loans are called in early then consumers have assets to pay them back. However, de-leveraging is painful, as we know in the West, and this could dent China's growth outlook for the rest of this year, threatening global growth prospects.

Overall, there is still a lot of uncertainty and risk out there and volatility could be here to stay.

All views expressed are the author's, not by association FNArena's (see our disclaimer).

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