As pointed out in a column in The Financial Express (‘Will more of the same last?’) on Wednesday, the US Federal Reserve, in its latest post-FOMC meet press conference, indulged in significant “linguistic gymnastics” to hedge for omission of “patience” from the “linguistic legacy” it uses to guide investor expectations. What can India’s markets expect in the months ahead? While it is impossible to state with certitude how events will unfold—the outcomes are state-contingent, not just to events in India, but also to triggers of global risk-off—our analysis presented here gives an idea of what might lie ahead.
The first signal of the extent of potential volatility is the level of risk being priced in various markets. Measures like ViX, global bond markets indices and credit spreads indicate that while episodic volatility is present (Greece, FOMC statements, etc), the overall risk pricing remains quite low. This is not good news, being similar to the levels seen just before the “taper tantrums” of early-2013.The extent of risk pricing is dependent on the pace, quantum and guidance of hikes signalled (however indirectly) by the Federal Reserve and the perception of investors. Fed Funds Rate (FFR) futures are currently pricing in a 25-bps increase as the highest probability in June 2015, although the gap over the ‘no-hike’ probability has come down.
The Fed has been using “dot-plot” charts to communicate its members’ projections of rate hikes since the last couple of years. The accompanying charts show the progression of rate hikes signalled by the dot-plots—first, after the meeting on December 17, 2014, and later, after the one on March 18, 2015. From a median increase of 1.125 by end-2015, the members’ views on rate hikes have moderated to 0.625. Based on our own calculations, we concur with this quantum. By the end of 2017, based on the current information set, Fed members believe that the FFR will be up at 3.25%.
One of the accompanying charts shows the Fed members’ projections (the kinked lines) juxtaposed with market pricing (smooth lines) of rate hike forecasts (Fed funds Futures). The takeaway is the narrowing gap between the Fed’s and markets’ expectations of the trajectory of rate increases between December 2014 and March 2015. This implies that the surprise element premium will have come down and, consequently, the potential of a “tantrum” volatility and risk-pricing shooting up reduced, once the rate hike appears closer to certainty.
When risk-pricing does indeed go up, what will be the quantum of the foreign capital flowing to emerging economies that will be at risk? In India, Foreign Portfolio Investors (FPIs) have brought in close to $28 billion in debt funds and $17 billion in equity over April to March FY15. That the access to T-bills and commercial papers has been closed is presumed to increase the investment horizons of FPIs and, hopefully, induce greater stability.
The overall economic environment for foreign capital has also improved significantly. There is little point in elaborating the improvement in the current account and fiscal deficit situations—which are partly due to a provenance of lower petroleum and commodity prices, but mostly through a set of concerted policy actions by the Centre and RBI.
One stability-inducing metric, which needs to be highlighted, is the quantum of foreign currency reserves held by RBI ($310 billion in mid-March, with an additional $20 billion in gold). The accompanying charts show that this is close to covering almost 9 months of imports. While still being significantly lower than the cover in 2007, this has improved over the past couple of years and the expected additional increase in reserves, coupled with subdued imports, will improve this metric in the months leading up to the Fed hike.
Given these arguments, India’s improved macro-fundamentals and growth prospects will, hopefully, make it less vulnerable to markets responses to the first Fed interest rate hike.
Tanay Dalal provided the logic, charts and calculations
The author is senior vice-president and chief economist, Axis Bank.
Views are personal.