Key Pointers Emanating from the Fed Funds Meet in December 2016…
- The Fed in its December meet decided to hike the Fed Funds Rate by 25 basis points from the range of 0.25-0.50% to the new range of 0.50-0.75%. This rate hike comes a full 1 year after the rate was last hiked by 25 basis points in December 2015.
- The Fed funds, as the graph above depicts, were cut sharply in the aftermath of the Lehman Crisis to the lowest possible range of 0-0.25%. It was kept static at that level of close to 7 years till December 2015.
- The tone of the Fed policy has been hawkish both in terms of front-ending of rate hikes and the trajectory. There is now a high probability of 3 rate hikes by the Fed in 2017 as against just 2 originally. Additionally, the trajectory of rates also stands enhanced to nearly 2% by end of 2017 and to 2.5% by end of 2018.
- The Fed has been largely driven by data flows. It had identified full employment, economic growth, higher inflation and rising wages as the key criteria for justifying a hike in Fed rates. However, in the last few policies, the Fed has made a distinct shift from historical data to focusing more on projected data.
- While unemployment at around 4.6% meets the definition of full employment, wages are hardly rising. Inflation is way below 2% and consumer spending is yet to pick up in a big way. However, the Fed bets that the sharp tax cuts which are likely to be implemented by Trump combined with massive infrastructure investments could create a virtuous cycle of higher growth, higher incomes and higher inflation.
- The first implication of this rate hike will be short term pressure on global markets. On the previous occasion, the 25 bps rate hike in Fed rates in December 2015 led to equity value destruction to the tune of nearly $12 trillion globally. Memories of Jan 2016 are fresh and some negative reaction is surely to be expected.
- The second implication of the Fed rate hike will be the monetary divergence. This divergence is an outcome of large economies having diverse monetary policies. Currently, the US is following a hawkish policy while Japan and the EU are following a dovish policy. This could add to volatility in global markets leading to value destruction across markets.
- One of the key outcomes of the Fed rate hike will be to make the dollar stronger. The US dollar has already touched a multi-year high and is quoting at above the 100 mark. The Dollar has also sharply appreciated most of the OECD currencies and this could have serious implications for economies that are dependent on China. A strong dollar will weaken the Yuan and force a currency war across emerging markets.
- Debt outflows in India are already visible since the month of November. India saw outflows worth $2.5 billion in the month of November and further outflows from debt to the tune of $2 billion in the first few days of December. These outflows could get further accentuated with the rate hike as well as the hawkish outlook given by the Fed.
- Strategically, dollar defensive stocks will be the key attractions in the Indian market. Sectors like IT, pharma, auto ancillaries and hydrocarbons will substantially benefit from the dollar strength. They could be the outperformers in the short to medium term in the Indian equity markets.
- However, over the longer term, Indian markets stand to benefit from the rate hike. A rate hike is a clear indication that the US economy is growing and poised to grow faster. A growing US economy is positive for a lot of dollar driven sectors. It also opens up new opportunities for India to expand its economic footprint in the US. Historically, Indian economy has tended to outperform other markets in the aftermath of a rate hike and this time around it will be no different, short term jitters notwithstanding.
- The RBI may have actually done a major favour by maintaining status quo in its December policy. Had the RBI cut rates in December, the gap between US yields and Indian yields would have compressed further resulting in further outflows from debt markets. In retrospect, it was wise on the part of the RBI to hold rates.
The rate hike by the Fed was a foregone conclusion. There was hardly any surprise element in it and was largely factored in by the global markets. Unlike in December 2015 when traders were hoping against hope for another status quo by the Fed, this time around there were very few illusions. That may substantially reduce the impact and shock value of the Fed rate hike. Of course, that will be evident only in the next few weeks.
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