US Fed Hike - Implications for India - Axis Mutual Fund

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Dec 3, 2015 - The document is prepared for general market understanding and should not be treated as research report. Mu
US Fed Hike Implications for India

December 2015

US Fed hike: Implications for India It has probably been the most long awaited quarter of a point rate rise in history, but the US Federal Reserve (Fed) has finally pulled the trigger by increasing the target range for the Fed funds rate by 25 basis points (bps), to 25-50bps.In the accompanying statement the US central bank noted the further improvement in the labour market and that “under utilisation of labour resources has diminished appreciably”. Although inflation has yet to return to target, it was expected to rise to 2% as the transitory effects of declines in energy and import prices dissipate. Taking into account domestic and international factors, they said the “risks to the outlook are balanced”.The immediate move has been well telegraphed and so should not come as a surprise to markets. The FOMC also said it expects to maintain the size of its balance sheet “until normalization of the level of the federal funds rate is well under way.”

Way forward for US interest rates While the first rate hike itself has been well telegraphed, the question now is how significant is the rate hike cycle going forward. All indications at the moment point to a very limited number of rate hikes next year. The current Fed forecasts implies 4 more quarter point rate hikes in 2016. The reason for the tepid cycle is that the US economy is significantly weaker compared to the previous rate hike cycles (refer table below). Whether it is the US and global economic growth, core inflation, labour force participation or wage growth, all of these parameters are running well below the levels seen in 2004 and 1994 when the 2 previous rate hike cycles kicked off.

December 2015 Indicator

Current

2004

1994

US GDP growth

2.2%

4.2%

3.4%

IMF Global growth

3.1%

5.4%

3.3%

US CPI Inflation

0.2%

2.8%

2.1%

US Core Inflation

1.3%

2.0%

2.3%

US unemployment

5.0%

5.6%

6.6%

US labour force participation

62.5%

66.1%

66.6%

(Source: Bloomberg)

US rate hike will have a limited impact on local fixed income markets One key overhang on the local monetary policy decisions as well as bond market yields in 2015 has been the impending turn towards normalization of policy rates by the US Fed. With the rate hike cycle finally underway, this can certainly have a shorter term sentiment impact, however we do not expect this to have a lasting influence on the direction of domestic rates. A good case study is provided by the experience in 2004-05 – the last time the US Fed had initiated a rate hike cycle. The interesting observation (refer chart below) is that even then local long bond yields continued to get much more influenced by local policy decisions rather than what was going on in the US. We expect the same to hold true this time along as well. Sooner or later the market will start realizing that for pricing Indian yields what RBI is saying/doing matters much more than what the US Fed does. It is also interesting to note that the current spread between the US and Indian 10 year yields remains close to its high over the last decade which provides a degree of comfort for long bond yields. 12

10 yr G-Sec Yield (%) US Fed Funds Target Rate (%)

10 8 6 4 2 0

Source: Bloomberg

Repo Rate (%)

December 2015

Equity Market implications While the rate hike does not directly impact equity fundamentals in India, the implications for equity markets flow through the sentiment and foreign portfolio flows channel. In this regard India as a significant member of emerging market equities basket will react on the basis of perceptions for overall EMs. Historically, the impact of rate hikes in the US on Emerging Market equities has been mixed and ultimately dependent on the circumstances at the time; the past two tightening cycles led to net capital inflows into EMs. Notwithstanding the above, ongoing divergent policy between the US and developed peers may well keep the USD supported and a strong dollar has tended to correlate with weak EMs performance relative to developed markets. So until investors have greater confidence that the USD has already done much of its strengthening, this headwind may have further to run. Thus, while a start to tightening in the US does not prevent EMs from performing in 2016, some stabilization in the USD is likely necessary.

Statutory Details: Axis Mutual Fund has been established as a Trust under the Indian Trusts Act, 1882, sponsored by Axis Bank Ltd. (liability restricted to ` 1 Lakh). Trustee: Axis Mutual Fund Trustee Ltd. Investment Manager: Axis Asset Management Co. Ltd. (the AMC) Risk Factors: Axis Bank Limited is not liable or responsible for any loss or shortfall resulting from the operation of the scheme. This document represents the views of Axis Asset Management Co. Ltd. and must not be taken as the basis for an investment decision. Neither Axis Mutual Fund, Axis Mutual Fund Trustee Limited nor Axis Asset Management Company Limited, its Directors or associates shall be liable for any damages including lost revenue or lost profits that may arise from the use of the information contained herein. No representation or warranty is made as to the accuracy, completeness or fairness of the information and opinions contained herein. The AMC reserves the right to make modifications and alterations to this statement as may be required from time to time. The document is prepared for general market understanding and should not be treated as research report. Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.