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Fed rate hike signal is over. Would you like to tweak it a bit

The Fed said US economy is strong enough to handle a rate hike. When it comes, it would be the first increase since the rate was cut to near zero during the 2008 financial crisis.

June 19, 2015 10:35 IST | India Infoline News Service
The US Federal Reserve didn’t bite the bullet to increase interest rates at the end of the two-day FOMC meeting yesterday, but it did signal that a rate hike is coming very soon.

The Fed said US economy is strong enough to handle a rate hike. When it comes, it would be the first increase since the rate was cut to near zero during the 2008 financial crisis.

Projections released by the Fed show less certainty that rates will rise before the end of this year, but many economists expect the first rate rise to come as early as September.

Investors across asset classes were waiting with bated breath for the signal from the US Federal Reserve. Over the past few days, there has been significant amount of anxiety even in the Indian financial markets, as foreign portfolio investors have withdrawn a large amount of capital from both equities and bonds over the past couple of weeks, leading to weakness in the stock market as well as in the rupee. The domestic currency hit a two-month low on Tuesday.

So why is there so much of worry really? The fact is the difference between interest rates in the US and India is huge now, which is why foreign portfolio investors are flocking to emerging markets like India where they can earn better yields on bonds and also on stocks as economies revive. But a hike in interest rates in the US may change the equation, making yields more attractive for FPIs. More so, because the US economy is already growing and better yields back home will prompt FPIs to repatriate capital from overseas markets.

However, a small one-time rate hike is not enough to make US yields more attractive for them. But a signal from the US Fed will ultimately lead to subsequent rate hikes and a series of hikes over a period will raise the borrowing cost for carry-trade (borrow from US and invest in India), and thereby reduce their risk-adjusted return in an emerging market, like India. Remember, the US is considered a safe haven market for investors looking for stable returns.

Plus, India is already witnessing a downturn in the interest rate cycle after the Reserve Bank of India has cut policy rates thrice this year. A rate cut in India and a rate hike in the US can narrow the existing rate differential and make US bonds more attractive. 

Then there is the rupee equation. A sudden rise in outflows from India can significantly weaken the rupee, which will make cut into the returns that FPIs have already generated on their investments here. Which is why many of the FPIs who are already sitting on big profits after the last year's rally in the market are trying to book profits and repatriate them before the stock market weakens further and the rupee too takes a tumble.

If the rate hike or at least a signal does come about tonight, it will surely trigger some turmoil across asset classes and also in the rupee. Chances are India with a significant dollar reserve and a substantial drop in inflation would be better prepared to face such a crisis this time around. Plus, any weakness in the market at this stage will spell big value buying opportunity for investors, as the prospect of the Indian economy can only improve from here on.

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