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Explained: Fed move and Indian markets

🔴 The US Federal Reserve has signalled a possible hike in interest rates soon, leading to a nervous reaction in Indian markets. How will the expected hike impact markets and the economy, and what should investors do?

Written by George Mathew , Sandeep Singh | Mumbai |
Updated: January 28, 2022 7:53:58 am
Federal Reserve Chair Jerome Powell. (Graeme Jennings/Pool via Reuters)

On Wednesday, the US Federal Reserve announced the final round of its asset purchases. It will thus conclude its balance sheet expansion in March, much ahead of its initial plan. The Fed will subsequently start to increase interest rates in the economy beginning March. Both these measures are aimed at taming inflation, currently at a four-decade high of around 7%.

Asian markets have reacted nervously to the decision, with premier indices in Japan and Hong Kong falling 3.15% and 2% respectively on Thursday, and the benchmark Sensex and Nifty at BSE and NSE too falling by up to 2.4% before recovering to close the day with a fall of 1%. Over the last seven trading sessions, the Sensex has lost over 4,000 points or 6.57%.

What has the Federal Reserve announced?

The Fed announced the final round of asset purchases in February, with balance sheet expansion concluding by early March, with indications that interest rates would soon be hiked given the backdrop. Fed Chair Jerome Powell noted that the Fed would have to be nimble in assessing the appropriate path for future policy. He was asked about the potential for a 50 bps rate hike and did not dismiss the idea outright, saying those kinds of decisions have not been addressed yet. He underscored that this period is nothing like the end of the last expansion as inflation is much higher.

“He is implying that they will need to move faster than back then. Since the Fed started with a one-year lag and then shifted to quarterly lag, this may or may not mean hikes at every meeting become likely later in the cycle,” said a Bank of America Global Research report. “… The bottom line is that the risks are skewed to more than 4 hikes this year, as we have been flagging,” the report said.

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According to IFA Global Research, the general understanding is that the Fed has prepared the market for a 25 bps hike in March. Powell said there is quite a bit of room to raise rates without hurting jobs. He did not rule out raising rates at every Fed meeting in 2022. He did not rule out hikes happening in increments of more than 25 bps at a time either.

Why are the markets falling?

The Dow Jones in the US closed with a fall of 0.4% on Wednesday, while the fall in the Indian markets was 1%. If a strong labour market and taming of inflation is seen as a medium-term positive development from the perspective of US economy and markets, emerging economies including India are viewing it from the perspective of fund outflows from equity markets, and expected rise in cost of funds in the economy and its impact on growth. This has therefore resulted in a sharper reaction in stock markets across emerging economies including India.

Over the last couple of months, already anticipating the rate hike and stimulus withdrawal in the US, Indian equity markets have been witnessing a sharp outflow of FPI money — Rs 64,000 crore since November 23. Experts feel the outflow can gather pace if there is an aggressive rate hike in the US.

“Market volatility could persist in the near term owing to the US Fed and other global central banks’ tapering programme along with potential rate hike. Apart from these, domestic factors such as the Budget and corporate earnings too are likely to hold sway in the near term,” said S Naren, ED and CIO, ICICI Prudential AMC.

The Federal Reserve building in Washington. (Stefani Reynolds/The New York Times)

How will the Fed action impact the economy?

The Fed tightening is likely to impact the cost of financing in emerging market economies and, sooner or later, the interest rate cycle will turn across countries, said an analyst. Taking into account the combination of rising prices and strong employment, analysts have projected the Fed’s benchmark overnight interest rate would need to rise from its current near-zero level to 0.90% by the end of 2022. That would kick off a hiking cycle that would see the policy rate climb to 1.6% in 2023 and 2.1% in 2024.  The run-up to the first Fed meeting has already seen a sharp correction in equity prices and rise in treasury yields in the US. Indian stocks and yields are now following the US trend.

When interest rates rise in the US, the gap between those and rates in countries such as India reduces, giving less incentive for foreign investors to pump money into overseas markets. This means foreign capital outflows can happen not only from equity but also from debt. In January so far, foreign investors have pulled out a net of Rs 22,722 crore from equity markets anticipating a hike in US fed rates.

Another impact will be on the rupee, whose value against the dollar will come under pressure due to capital outflows. The rise in rates also means higher cost of funds, and fund mobilisation in overseas markets will be costly. For India, the upward pressure on interest rates comes at a time when the Covid-hit economy is on a comeback trail in an uneven manner. There’s also a significant gap in both private consumption and investment, relative to pre-pandemic levels in 2019-20.

The increase in cost of funds may not only increase the cost of capital expenditure for India Inc and increase the cost of developing infrastructure for the government, but will also strain the profit margins of companies.

What other factors could impact Indian markets?

These include the growing geopolitical tension between Russia and Ukraine, and a spike in crude oil prices to levels of $89 per barrel.

With Finance Minister Nirmala Sitharaman set to present the Budget next week, markets would be keenly watching the government’s reform agenda, fiscal roadmap and demand and growth push in the economy. Experts say that if the government goes for a populist Budget ahead of elections in five states including the key Uttar Pradesh, it could have a negative impact on the markets.

What should investors do?

Although the markets are expected to remain volatile in the near term, investors should not panic if they see a 1,000-1,500 point fall in Sensex. But it is also important to avoid mid- and small-cap companies while picking their investments as these could be more vulnerable to a rise in interest rates and input costs among other factors.

While equity-overweight investors would be wise not to aggressively invest in equities and should redeploy some of the funds in hybrid schemes, experts say investors who are underweight in equities can utilise dips in the market to increase their equity portfolio.

“The optimal investment approach in such a scenario is to stay focused on asset allocation and opt for a combination of active management and multi-asset strategies. In case you are considering equity-related investment, invest with a long-term view and opt for business-cycle-based funds as India’s business cycle remains robust. Another option is to consider scheme categories which have the flexibility to invest across market capitalisation and themes and use features like Booster STP,” Naren said.

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