Explained: US rate hike and the markets

The move is aimed at keeping a check on inflation, which faces an additional threat on account of the war in Ukraine. Inflation in the US hit a four-decade high of over 7.5% even before the Russian invasion. “With appropriate firming in the stance of monetary policy, the Committee expects inflation to return to its 2 percent objective and the labour market to remain strong. In support of these goals, the Committee decided to raise the target range for the federal funds rate to 1/4 to 1/2 percent and anticipates that ongoing increases in the target range will be appropriate,” the Fed said.

Source: Fed via NYT

Will the RBI too hike rates?

While there is no indication that the RBI will increase the key policy rates in its April policy review, it’s likely to revise the growth forecast in the wake of the Ukraine war. It also remains to be seen whether the RBI will retain its accommodative policy stance.

RBI Governor Shaktikanta Das recently said central banks are in a bind as the recent geopolitical developments have further aggravated its challenges and dilemmas. “If they act aggressively to contain inflation which may perhaps subside as normalcy returns, they run the risk of setting in recession,” Das said.

On the other hand, if they act too little and too late, they may be blamed for “falling behind the curve” and may have  a lot of catching up to do later, which will be detrimental to growth, Das said. If the RBI hikes rates and tightens liquidity, markets are likely to take it as a negative.

Federal Reserve Chair Jerome Powell (Tom Williams/Pool via Reuters, File)

How did the markets behave, and why?

While news of the rate hike initially pulled the US markets down, the Dow Jones Industrial index eventually closed Wednesday with a gain of 1.6%. Asian markets opened with big gains on Thursday: the Nikkei in Japan rose 3.5%, and the Hang Seng in Hong Kong closed with a gain of 7% on Thursday. The benchmark Sensex too closed with a gain of 1.84% at 57,863.93 on Thursday.

Market participants say the rate hike did not come as a surprise. The expected hike was already priced into the market and foreign investors were liquidating their positions in anticipation of the move. Foreign portfolio investors (FPIs) have pulled out a net of Rs 1,36,487 crore from Indian equities since November 1. Many feel that even though some outflow could still be seen, most investors who needed to exit on account of the Fed’s move had already taken that call.

On the other hand, what provided comfort to the markets was the Fed’s statement on growth and employment. It said indicators of economic activity and employment have continued to strengthen, job gains have been strong in recent months, and the unemployment rate has declined substantially.

Moreover, crude oil prices, which hit a 14-year high recently, also came down sharply — from $130 a barrel ten days ago to $100 now. Over the last few trading sessions, the markets have also been drawing comfort from the progress of talks between Russia and Ukraine.

How does an interest rate hike in US impact the markets?

An interest rate hike in the US results in outflow of funds from emerging markets and into US treasury bonds. The outflow weakens the equity markets and leads to a correction. As this Fed move was anticipated, FPIs had been liquidating their holdings from Indian equities in the last three or four months, leading to weakness and correction in Indian benchmark indices. Experts feel that the FPIs, having already pulled out funds in anticipation of rate hike, are unlikely to go for a knee-jerk reaction now. On Thursday, FPIs made a net investment Rs 2,800 crore, indicating that their selling has abated for the time being.

On the other hand, the possibility of a truce between Russia and Ukraine, decline in unemployment rates in the US and better growth expectations could be beneficial for equity markets in the medium term and FPIs may start coming back in a few months.

What should investors do?

While the markets have witnessed a smart recovery over the last one week and have risen 9.5 % since they closed at 52,842 on March 7, investors should not throw caution to the wind. The war continues, and so does the threat for markets. Investors need to remain wary of the volatility in the market and avoid aggressive lumpsum investments. It is better to go through a systematic investment plan (SIP), and into well-established blue-chip companies and large-cap funds. Global markets, including India, have been very volatile in 2022 so far. Experts say that while investors should not expect returns of the kind seen in the second half of 2020 and through 2021, they should enter the markets with at least a three-year horizon.

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