On the 31st July when the Federal Open Markets Committee (FOMC) concluded its meeting, it took a call to cut the Fed funds rate by 25 basis points. This effectively took the benchmark rate from a range of 2.25-2.50% to a new range of 2.00-2.25%. What was the logic for this rate cut and how should Indian markets interpret the same?
First rate cut in 10 years
The rate cut was always on the cards and the CME Fedwatch tool had already hinted at a 100% probability of a rate cut in July! In fact, the CME Fedwatch tool was actually split between a 25 bps rate cut and a 50 bps rate cut. The FOMC statement was quite clear that the rate cut was being undertaken in the light of the improved growth, higher levels of consumer spending, lower rate of unemployment and interest rates being stable at around 2%. The FOMC underlined that a rate cut of 50 bps would have been too aggressive and future rate cuts would be driven by data flows. While the Fed has not ruled out further rate cuts, it has desisted from giving any commitment on the future direction of rates. In another significant move, the Fed also indicated that the bond reduction program of the Fed will be wound up 2 months earlier. This is a clear signal to the markets that the Fed will keep the liquidity levels in the system comfortable. The Fed rate has to be actually looked at in conjunction with this commitment on liquidity.
How should RBI interpret?
For the RBI, there are 2 key takeaways from the Fed action. Firstly, the rate cut initiative by the Fed is significant in the sense that it clearly signals a shift towards easy money policy across central banks. This approach has been affirmed not only by the Fed but also by other central banks like the ECB, Bank of England and the Bank of Japan. This largely gives the RBI a perspective on how it needs to structure its thinking. After all, in the interconnected financial system, it is not possible for any central bank to stay decoupled with the bigger central banks for too long. Secondly, the cut also implies that the risk of capital outflows from debt may not be too material. The rate differential will still be maintained even if the RBI cuts rates by 25 basis points in its August policy.
What about equity markets?
In the last 20 years, there have been 3 occasions when the Fed has hiked rates sharply; 1998, 2004 and 2016. On the first two occasions, the subsequent cut in rates took the Fed rates to lower than the pre-hike levels. It is from this point of view that the markets will look to interpret the first rate cut by the Fed in the last 10 years. Will this rate cut mark the beginning of the rate cut cycle? In the past, catching Indian equities at this point of the Fed cycle has been extremely profitable in the long run. That could be the real takeaway! ©