Equities can outperform while bonds will also do well
US credit rating downgrade will not hugely affect the INR, while the Nifty can catch up on its underperformance to the Dow. Bond yields will come off on slow growth worries in the US.
The unthinkable has happened, the US government credit rating has been downgraded to AA+ with a negative outlook by the rating agency S&P. The downgrade happened after market hours on Friday the 5th of August and everyone is looking at what will happen on Monday the 8th of August when markets open in the morning. Over the weekend the issue has been thrashed out with many predictions from “nothing is going to happen” to “the US Dollar (USD) will lose its status as the world’s reserve currency”.
How does the rating downgrade affect India specifically? Will the Indian Rupee benefit from the downgrade? Will India’s debt become more attractive to FII’s and will Indian equities see benefits of FII flows on the back of USD depreciation? To answer these questions, the focus should be on what is the relevance of the downgrade?
The downgrade from AAA to AA+ negative will force US debt holders to value the debt one notch below in terms of valuation metrics. The US debt is the most liquid and widely traded debt in the world and US government bond holders including China (which is the single largest holder of US debt) do not really have to search for prices to value the debt. Ten year US treasury yields are at 2.56% levels. Unless there is a sell off in the market, bondholders will value the ten year treasuries at 2.56%. In fact ten year treasury yields are down almost by 80bps since April this year on the back of worries on economic growth. US banks holding US treasuries will treat it as risk free and that will not prompt any sell off in the market. Going down the line, treasury yields will move depending on direction of inflation, growth, Fed policies and demand for US bonds from other countries. Hence, immediately there will not be any sustained sell off on treasuries.
If there is no sustained sell of on US treasuries, the USD too will not be affected. The USD is trading at levels of 10% below where it was last year against the majors. The USD depreciation was due to worries on US debt and US Federal Reserve’s accommodative monetary policy. There has to be extremely negative sentiments against the USD for it to be sold off further.
The debt downgrade, if it does not have a sharp repercussion on the USD, which seems to be the case, will not have a negative or positive effect on the Indian Rupee (INR). The USD/INR pair is trading in a Rs 44 to Rs 45 range for a while and at current levels of Rs 44.75 to the USD, the INR is unlikely to breach the range conclusively on the downside or on the upside. In fact the INR has come off against the USD by a percent over the last few days on the back of the global turmoil in markets.
Indian equities have some catching up to do with US equities. The Dow has outperformed the Nifty by almost 14% over the last one year (as of July 31st). The last one week has seen the Nifty doing better than the Dow by around a 1%, but that is not much. The downgrade will help the Nifty to catch up on the underperformance.
Indian bonds have underperformed its US counterparts by around 4% as US bond yields have dropped over the last one year by 12bps while Indian bond yields have moved up by 65bps. (Ten year benchmark bond yields as of July 31st 2011). The downgrade itself will not have a positive or negative impact on Indian bonds, but a weak outlook for US growth can bring down commodity prices, which will bring down inflation expectations in India. The RBI is likely to pause on its rate hike cycle where it has raised rates by 250 bps over the last one year and this will have a positive effect on bond yields.
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