Fed rate cut: Brave act or desperate move?

On September 17, he announced the first rate cut of his tenure — a 50 basis points (bps) cut in the Fed Funds Rate (the inter-bank borrowing rate), bringing it down from 5.25 to 4.75 per cent. This cut is expected to boost consumer spending, improve corporate bottomlines (by reducing interest costs), and boost the US — and world — economy. In addition, the Fed also reduced the Discount Rate (the rate at which it extends short-term loans to banks) by 50 bps, a move that will make cheaper funds available to banks.

Markets surge

Markets around the world celebrated Bernanke’s measures: the Nikkei rose 3.7 per cent, Hang Seng 4 per cent, FTSE 2.8 per cent, DAX 2.3 per cent and CAC-40 3.3 per cent. The Indian market, too, responded positively: the Sensex rose 4.2 per cent, in the process breaching the key psychologically mark of 16,000. (It has taken a mere 51 trading sessions for the Sensex to move up from 15,000 to 16,000.)

While the markets have taken the positives from Bernanke’s rate cuts, the negative implications of his decision don’t appear to have sunk in completely. Bernanke had earlier said that he would go for a rate cut only if there was a genuine problem in the US economy, and not just to bail out the banking system. Now, does the 50 basis points cut point to a larger problem in the economy?

Many experts believe that the US economy might be headed for a slowdown, which would lead to greater flight of capital into those high-growth economies that depend less on exports and are propelled more by domestic consumption. Says HDFC Bank chief economist Abheek Barua: “India, Indonesia and China are likely to hold up and are being seen as safe havens by investors.”

…And rupee follows suit

The higher influx of funds that followed the US rate cut led to further appreciation of the rupee, which on Thursday breached the Rs 40 to the dollar mark for the first time in nine years and closed at Rs 39.88.

How will the appreciation of the rupee impact our economy and the stock markets? One, by reducing the oil import bill, the stronger rupee will benefit oil companies. The BSE Oil & Gas index gained 11.4 per cent last week. Reliance Industries Ltd (RIL) gained 11.8 per cent, RPL 18.6 per cent,and ONGC 10.7 per cent. While the Oil & Gas sector has benefited from the rupee appreciation, the IT sector’s earnings are likely to be squeezed even further.

Not surprisingly, the BSE IT index was down 0.5 per cent over the previous week’s close. Satyam and Wipro were down by 2.75 and 2.3 per cent respectively. Infosys and TCS tried to hold their ground but they, too, lost 0.46 and 0.75 per cent respectively over the previous week’s closing.

Selective gains

What is noteworthy is that most of the movement on Wednesday was largely concentrated in the large-cap segment, which foreign institutional investors (FIIs) tend to prefer. The Sensex was up 4.2 per cent, the BSE 100 3.7 per cent, and the BSE 200 3.5 per cent. By contrast, mid-cap and the small-cap indices gained only 1.9 per cent and 1 per cent respectively.

“In future, activity is likely to take place in companies beyond the large cap companies,” says JP Morgan AMC chief executive officer (CEO) Krishnamurthy Vijayan. “The action in the leading stocks has been because of increasing movement of capital from developed economies to emerging markets.

India is likely to see an increase in investment in smaller companies moving beyond the top 50-100 stocks that most foreign investors and mutual funds are today pouring money into.” Over the past year, too, gains in the stock market have been selective. While the Capital Goods and Oil & Gas indices have gained by 78 and 59 per cent respectively, the Auto index has declined by 0.5 per cent.

The BSE IT and BSE Healthcare indices have grown by a mere 0.2 and 1.9 per cent respectively. So, it has not been an all-round gain, and interest rates and currency appreciation have had a major impact on the performance of sectoral indexes.

Gold: The safe haven

With the dollar losing ground, one asset class that has gained significantly is gold. Gold acts as the alternative reserve (to the dollar) for central banks around the world and as a hedge in times of uncertainty. Gold closed at Rs 9,550 per 10 grams on Friday, up 2.9 per cent during the week. With the dollar on the decline, gold appears to be emerging as the favoured asset class and is expected to remain fairly strong in future.

Long-term scenario

Once the stock market euphoria witnessed last week subsides, it remains to be seen whether the Fed’s actions actually stem the subprime crisis, or whether the markets in future have to deal with a recession in the US economy. If that were to happen, markets around the world would get impacted.

Says Barua: “The rate cut could be implying that things are much worse in the US than people expected. If the growth rate in the US economy gets revised downward, it will impact the G7 nations and all the other economies too.”

For India and a few other Asian economies, the positive comes from the fact that these economies, being driven more by domestic consumption, are likely to weather a US recession much better, and it is likely that more investments will flow into their economies and markets.

Bend it like Bernanke

• Fed rate cut expected to provide a fillip to subprime mess-plagued US economy

• Markets around the world responded euphorically to the cut

• Interest rate differential between US and India has widened

• With more funds flowing into India, rupee breached 40 per dollar mark

• Will the present cut protect the US — and world — economy from recession?

• If not, the feel-good induced by it may prove temporary