Fed Funds rate may finally rise…

The announcement made by US Federal Reserve Chair, Janet Yellen, on Wednesday was unambiguous to say the least. The word “Patience” has been dropped from the Fed statement which implies that the Fed may not wait much longer to raise interest rates in the US. The Fed surely has genuine reasons for the same. US labour data has been extremely strong and the US economy has grown at 2.2% in the December quarter after another robust 5.5% growth in the previous quarter. Of course, the Fed has a target of 2% inflation for rate hikes, which is likely to happen only if oil prices stop their free fall. But it looks like the month of June 2015 may see the first rate hike from the US Fed. Interestingly, if it happens, it will be the first rate hike by the Fed since 2006 (after a gap of a full 9 years). But firstly, why should India and other emerging markets be so worried about rising rates in the US?

The answer: It squeezes global liquidity…

A rise in US rates will mean that US bonds become more attractive and hence will see global funds increasingly allocating funds to the US and selling out of risky emerging markets like India, Brazil, China, Thailand etc… For the Indian economy, which has been receiving over $45 billion of FPI inflows annually, this is not great news. There is another important angle of dollar appreciation. The demand for dollar assets increases as they are confident that as long as rates are moving higher, the dollar will get stronger. Therefore it makes more sense for foreign investors to be invested in dollar assets. Let me explain…

Assume that a European investor invested Euro 100 in a US bond last year when the exchange rate was (1.40$ / Euro). He would have effectively invested $140 at that exchange rate. Assuming that he would have earned a 2% yield in one year, he would get $143 at the end of one year. Now comes the real catch! The dollar has appreciated in the last one year to (1.04$ / Euro); which means when converted he gets almost Euro 142. Effectively Euro 100 has grown to Euro 142 i.e. a whopping 42% return in one year. Even if you consider all the transaction and translation and hedging costs, the return will still be attractive. With inflation and interest rates near zero in Europe, there is no inflation risk too. That explains why the demand for US assets will soar once rates are hiked.

For India: Some bad news, but not much to worry about…

Assuming that the rate hike happens in June and again in September this year, one can look forward to a bunching of outflows from emerging markets. India is not likely to be spared. However, with a growth rate in the range of 7.5-8%, Indian may be better off compared to other emerging markets. The immediate impact will be on the Indian rupee, which could see premiums moving higher and depreciation versus the US dollar. While the extent of outflows may be hard to predict, one can safely expect the Indian rupee to feel the pressure. From an investment strategy perspective, it may be time to seriously look at dollar defensives. More on that later!

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