Figure 1- Fed Funds Rates over last 5 years
The chart above depicts the Fed funds rate movement in the last five years. Between 2016 and 2019, the Fed hiked rates from a low of 0.25% to 2.50%. However, since mid-2019, the Fed has cut the rates by 75 bps to the range of 150-175 bps, including the latest rate cut in October.
What the Federal Reserve actually said
In his post FOMC statement, Jerome Powell underlined that economic activity and the labour market had remained strong with record low levels of unemployment. In fact, US unemployment has been at a 45 year low for quite some time now. Despite rising household spending, the FOMC saw the need to cut the rates due to weak business fixed investments and tepid exports. To a large extent, the weak exports were an outcome of the ongoing trade war with China, which has badly hit US farm exports. Powell also pointed out that key inflation indicators were below the 2% mark but pointed that further rate cuts would be largely data driven.
More important than the rate cut was the affirmation that the Fed would continue to maintain rollover and liquidity infusion to the tune of $20 billion per month in future too.
What the Fed rate cut means for India?
For India, the rate cut could have multiple implications because the impact is not just from rates but also from currency and market liquidity. Here are the key implications for India.
- First and foremost, the rate cut by the Fed paves the way for another rate cut when the RBI meets in December for its next Monetary Policy announcement. Growth continues to be a major issue and the last MPC minutes highlighted that the RBI would be willing to cut rates till the growth revived. The only X-factor was the US rate action. With rates cut, US bond yields could trend in the range of 1.50% to 1.80% leaving the Indian benchmark with a clear spread of over 450 bps.
- The yield spread between the US and Indian bonds as a result of the Fed rate cut will continue to remain attractive for global bond investors and the December rate cut by the RBI can now happen without overly worrying about losing out on the yield spread. Also, the risk-off sentiments that have been prevailing could change and flows could gravitate more towards EMs like India. That will be positive for flows.
- One concern could be the not-so-dovish outlook for rates given by the Fed Chair. Even if you look at the probabilities assigned by the CME Fedwatch to a rate cut, the probability of status quo in December is as high as 82%. Also, the probability of status quo even by November 2020 is as high as 40%. That could mean the dollar would strengthen from current levels and the dollar index (DXY) could be a risk for Indian markets. The Indian Rupee could come under pressure as a result.
- Finally, the real good news for the Indian markets could be on the liquidity front. The Fed note has clearly hinted at the focus on maintaining adequate liquidity in the US financial system with all discussions of bond tapering virtually shelved. That is good news for Indian markets. India has traditionally benefited from easy liquidity in global markets and this means that other central banks may also follow suit.