A rate hike by the US and prospects of faster hikes therefore is a signal to the world that the US economy is now ready to rise and shine from its slumber. Not far back in 2006 the Federal funds rate was 5%,so there is a lot of room to hike. However Fed is highly unlikely to raise rates to 5% as its own assessment is that 2% is what is good right now, which will be achieved in the next one and half years. Hence US rates are not as scary as markets make it out to be.
A strong US economy will pull up the rest of the world including India and that bodes well for Sensex & Nifty.
On the 6th and 7th of December 2016 the fifth bi monthly monetary policy meeting of the RBI was held. The Indian ten year bond yield rose by 24bps post policy.
On Wednesday late evening of 14th December 2016 India time, the US Federal Reserve chief Janet Yellen raised the key interest rates by 25 bps (0.25%) and next day Indian 10 Year bond yield rose by 14bps.
The RBI Governor and the Monetary Policy Committee went against the consensus view and held rates, The Federal Reserve chief Janet Yellen raised interest rates by 25 bps, which was widely expected and gave signals that the Fed may hike much faster next year if the US economy shows strength.
Common sense suggest that what Fed does or does not do to its own interest rates should not matter to us very much and our own rates should have a greater impact. Although the movement of bond yields suggest that the RBI Policy impacted us more, bear in mind that the RBI policy went against more than 95% of the widely held consensus view. The effect of Fed rate hike, which was supposed to have been priced in, impacted Indian bond yields a lot and more importantly turned sentiment from bullish to bearish.
The prospect of faster rate hike has sent jitters down the spine of bond dealers across the world including India. In fact one of the important reasons why the RBI Governor did not cut rates was the near certain prospect of Fed raising rates.
What is it About the Fed and prospects of it Raising Rates Even a Measly 25 bps, So Chilling to the World and more so to the Emerging markets?
If US raises rates then yields on US government bonds will increase. So fund managers will prefer to invest in US bonds. This may prompt them to sell some other countries bond holdings, which more often than not will be an Emerging Market Country bond. They may also sell equities of an emerging market as they invest primarily in search of higher returns.
A Rate Hike Mean a Stronger USD
A Stronger USD is scary to the world in general. It is only good news for exporters who get revenues in dollars. To others, imported raw materials become more expensive, competition stiffen and margins get squeezed. It may increase the price of finished goods and spur inflation or their products may become uncompetitve. Companies who have taken dollar denominated loans without hedge may have to pay more if dollar is more expensive.
For India, crude which is the biggest component of our import bill is denominated in dollars, so a stronger dollar is bad news.
A Strong USD Means the Value of Gold Goes Down
When the dollar gets strong, gold appears to go down, and vice versa. That accounts for part of the fluctuations that we see in the value of gold.
The correlation is that when the US Dollar gets stronger,it takes fewer dollars to buy any commodity that is priced in USD. When the US Dollar gets weaker it takes more dollars to purchase the same commodity. The price of all US Dollar denominated commodities, like gold, will change to reflect the fact that it will take fewer or more dollars to buy that commodity.
If Fed hikes rates and strengthens the USD, which is negative for India, why are we bullish on Indian equities? The reason is that at this point of time the commodity cycle is still weak with prices down 50% from peaks seen in 2007. Oil too is down by more that 65% from peaks seen in 2007. Hence, a stronger USD is not having much of an impact on our import bill and is not leading to inflation.