When the FOMC board met on March 14th and 15th, the rate hike of 25 basis points was already factored in. Hence the FOMC decision to hike the Fed rates by 25 basis points hardly came as a surprise for the markets. What should actually gratify the markets is that the Fed has taken a calibrated approach to future rate hikes and has indicated, at best, another 2 rounds of rate hikes this year. With the Fed rates currently in the range of 0.75%-1.00% after the latest hike, we could see Fed funds rate going up to 1.50% by the end of 2017.
9 Key things investors need to understand about the Fed rate hike…
- The Fed raised its Benchmark rate by 25 basis points to the range of 0.75%-1.00%. This is the 3rd rate hike by the Fed since the process began in December 2015. The earlier two rate hikes of 25 bps each had happened in December 2015 and then in December 2016. This rate hike gap within a gap of just 3 months signals further rate hikes in the calendar year.
- The decision to hike rates was largely driven by stronger consumer inflation, stronger jobs data and expectations of a robust turnaround in GDP growth and consumer spending. The Fed is trying to keep the economy growing at an even keel and hence the monetary policy is likely to desist from becoming too expansionary or overly contractionary.
- The trajectory of the rates is likely to be determined based on the how the Fed estimates for inflation, jobs and GDP growth pans out for the next 2 years. Currently, the median estimate for the next 2 year is 2% for inflation, 4.5% for unemployment and 1.9-2% for GDP growth. All these are fairly benign projections from the current levels and hence the Fed is likely to be very much calibrated in hiking rates.
- Based on the Fed outlook, Janet Yellen has roughly hinted at about 2 rate hikes of 25 basis points each in the current calendar year. That will take the overall Fed Funds rate to 1.50% by the end of this year. That will surely qualify as a fairly benign approach to rates by the Fed. Even the Fed Futures Trading on the Chicago Mercantile Exchange (CME) is factoring in the probability of a maximum of 2 rate hikes in this calendar year.
- Bond yields globally have already started going up and the trend could continue with another 2 rate hikes expected this year. That has led to capital losses on bond holdings. From an Indian perspective, the RBI may virtually rule out any repo rate cuts in the April and June monetary policy to ensure that the rate differential with the US benchmark is maintained. The rate differential is essential to incentivize FPI debt portfolio investments in India.
- For an equity investor, the higher rates may mean a higher cost of capital. That should technically be negative for equity valuations. While that argument is technically correct, it does not work like that practically. Markets tend to interpret Fed rate hikes as a signal of economic robustness and with an annual GDP of $18 trillion, which is surely going to be a huge impact.
- Even historically, the equity markets have been positively correlated with rate hikes. For example in 1994 and 2004 when the US Fed opted for sustained rate hikes, the S&P Index actually yielded positive returns over the rate hike period. Even in the 1987-89 period, when rates were on the way up, the US equity yielded positive returns even after considering the impact of Black Monday in 1987. On the contrary, the sharp rate cuts post sub-prime between 2007 and 2008 was accompanied by a 40% correction in the US markets. So, equity markets actually have reason to cheer the rate hike.
- So how exactly, will the Indian markets react? If early indications are anything to go by, then the reaction will remain positive. How much higher the markets will go also depends on domestic factors like quarterly results, inflation etc. However, a robust US economy and a strong dollar will be overall positive for the Indian markets. This applies to dollar defensive stocks as well as to the market overall.
- That brings us to the last question of how the RBI will calibrate it rate action after the recent Fed decision. If you look at the MPC minutes of February, then there is a clear mention of the RBI shifting its monetary policy stance from “Accommodative” to “Neutral”. That means rate cuts by the RBI are virtually ruled out in the April and June policy. Future trajectory of rates will depend on how the Fed rate hikes pan out, how the domestic inflation pans out and the liquidity situation domestically. But markets will have to be prepared for a lull in rate cuts for now!
You can ask us your stock related questions with #AskReligareOnMarkets via our Twitter channel @religareonline