Concerns about the US Federal Reserve regarding its rate hike has sparked a global sell-off. Most of the global markets including the Indian markets have been bearish since the previous six trading sessions.
The Federal Open Market Committee (FOMC) meeting is a regular meeting held by the Federal Open Market Committee, which is a branch of the US Fed. It meets about eight times a year.
It is expected that the US central bank may tighten its monetary policy for the first time after 2020. In order to counter the economic impact of the pandemic, it reduced its borrowing costs to near zero in the year 2020.
There have been a total of four rate increases this year in Fedfundsfutures that track short term rate expectations. At the end of this year, it is expected to start reducing its stockpile of treasury and mortgage bonds.
Economists from Goldman Sachs see a risk that the Fed will tighten the monetary policy more aggressively than what was anticipated. It might give a final set of instructions on bringing its asset purchase program to an end.
This might happen by mid-March, which is the same time around which the first interest rate hike might happen.
What has the US Fed done so far?
The US Fed began a quantitative easing programme as the pandemic broke out. It would purchase bonds worth $120 billion every month to ensure liquidity. In the second half of 2021, it was prompted to change tack due to inflationary pressures, jobs recovery and supply-demand mismatches.
It said that it would reduce its bond purchases by $15 billion every month, then it doubled it to $30 billion a month and quickened the process of tapering. The money parked in the Fed’s reverse repo continued to increase and touched $1.6 trillion in December 2021, thereby indicating a liquidity surplus.
When the Fed was buying bonds, money was created by and it intended to reduce longer-term rates to spur borrowing and spending. It was helping fuel stock market gains by pouring cash into the financial system.
In 2018, when the Fed raised rates and reduced its balance sheet simultaneously, the S&P 500 index fell by 20% in three months. If the same happens in March, as expected, it would lead to a wide range of borrowing including credit cards, mortgages, auto loans, and corporate credit.
Higher borrowing costs would slow spending and weaken corporate profits. If this goes on for long, it might result in a recession.
How does the US Fed rate decision impact India?
There has been a relation between the US Fed rates and the Indian markets. Changes in a few base points in the US Federal rates result in swings in the Indian markets. During FY21, there was a record high investment of $2.74 trillion in the Indian stock market.
Foreign investors take loans from the US markets where the rates are relatively low and invest the money in emerging markets like India, where they get higher interest rates. When the borrowing rate in the US goes up, they tend to invest less, as their cost of investment increases.
Then they pull out the money from Indian or other emerging markets globally and invest in the US. This makes the Rupee weaker in comparison to the dollar. The ones who withdraw money are usually short-term foreign investors.
When the US bond yields rise, it results in capital outflows and pressure on the Indian currency. This happened in 2013-14 as well, during the ‘taper tantrum’ when India had to take several measures to stabilize the cash flows and support the rupee.
Currently, India is in a better position with record forex reserves, a stable currency and inflation being in the RBI’s tolerance band.
The RBI (Reserve Bank of India) however takes measures to adjust this as it has adequate foreign reserves. If this does not work, then the RBI cuts interest rates and tries to give an immediate boost from retail participation.
Indian markets have been under selling pressure since January 18, 2022. Since then, both the Nifty and the Sensex have been shedding 6% in a week. FIIs have been withdrawing their investments and this has drained $ 1.26 billion from the Indian equity market this month.
However, domestic institutional investors (DIIs) like insurance firms, mutual funds, banks and pension funds have been making the most of this opportunity by buying shares worth ₹7,430.35 crores, this month. This has helped to cushion the fall to some extent.
Amid the Fed tapering talks, domestic yields have been steadily rising in a narrow band, and the yields are expected to continue northwards in Q4 as the benchmark G-secs rates could move in the range of 6.4-6.8, which is pre-pandemic level, even though the signalling repo rate may be capped at 4 per cent at the next policy meeting, SBI chief economist Soumya Kanti Ghosh said in a report.
Through much of FY23, a spread of 275 bps over the repo rate may be the risk spread, given the demand-supply inequality and this means that better risk pricing always results in better price discovery in markets, Ghosh added.
Ghosh expects only a gradual unwinding of the liquidity overhang in the banking system as the RBI has been conscious of the multi-paced recovery and is unlikely to change its rate stance any time soon, though it might move towards a liquidity neutral strategy.
Impact of the Fed’s move on other asset classes
Bond yields have surged globally in the last few weeks since the Fed’s stance to contain high inflation has prompted investors to prepare for a faster end to the monetary policy.
The 10 year Indian Government bond yield and the 10-year AAA-rated corporate bond yields were pushed up due to a surge in the global bond yields. Once the US Fed tightens the rates, there will be a faster than expected correction in the equity bond yields.
Analysts at Credit Suisse Wealth Management (India) do not expect Indian equities to de-rate materially in the next few months.
A General Rule
Developing economies like India always benefit when the interest rates are reduced by the US Fed as it lures foreign investors towards the Indian Economy.
However, it has to keep a check on inflation when this happens. These changes do not happen overnight, and there is ample time to prepare to counter the increase in the US Fed rates.
On the other hand, when the rates increase, the economy is impacted negatively as the market goes down. Foreign investors sell off their investment and foreign reserves deplete.
This increase might not only draw investors from the US to sell their investments, but also investors from other countries might do the same.
