US Fed Hike - Implications for India - Axis Mutual Fund

Dec 3, 2015 - 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. Equity Market implications. While the rate hike does not directly impact equity fundamentals in India, ...
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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