By Ashley Coutinho
The country’s equity, bond and currency markets may be in for yet more volatility if the US Federal Reserve opts for a 100 basis points rate hike this week or if the forecast for the terminal Fed funds rate moves up a notch or two.
The probability of a full percentage point hike increased dramatically after consumer inflation in the US surged to a 40-year high in June, up 9.1% year-on-year. But some of the more hawkish Fed officials still favour a 75 basis point hike, according to reports. Markets have pencilled in a terminal rate (the point were the federal funds rate will peak) of 3.75% for now.
“A 75 basis points rate hike seems to be a done deal,” said Andrew Holland, CEO, Avendus Capital Public Markets Alternate Strategies. “What remains to be seen is whether the market will be comfortable with front-ended rate hikes and the unintended consequences that follow.”
A few days ago, the European Central Bank (ECB) surprised the markets by raising its benchmark deposit rate by 50 basis points to 0%, its first rate increase in 11 years.
“A percentage point rate hike by the Fed may not be factored in and may lead to higher volatility in the equity and currency markets, and trigger yet more FPI outflows,” said Gautam Duggad, head of research – institutional equities, Motilal Oswal Financial Services.
FPIs have net sold equities worth $19.6 billion since the war broke out between Russia and Ukraine on February 24. Net sales in the year to date is $27.5 billion, although the past few days have seen inflows tipping the July net flows into positive territory.
“This relentless selling by FPIs has pushed foreign ownership of Indian stocks to a 9-year low of 19.4%, below the 10-year average of 20.2%. Even after such outflows, the risk of further FPI outflows cannot be ruled out, especially if aggressive central bank rate hikes continue and oil prices remain uncomfortably high,” said Jitendra Gohil, head of India Equity Research, Credit Suisse, in a recent note.
The rupee has depreciated 7.2% against the dollar, slipping to a historic low of 80 to a dollar last week. Yields of 10-year government securities are ruling at 7.41%.
The currency may be in for more pain if the dollar surges again, which is a possibility given the divergence in monetary policy actions around the world, said Ananth Narayan, associate professor at SP Jain Institute of Management and Research. He expects the dollar index, currently at 106.55, to test 110 levels in the coming months.
“All of this will put pressure on emerging market central banks, including the RBI, to follow suit with monetary tightening. Even if our MPC eventually raises our repo rate to 6%, the interest rate differential between the US and India (and hence the USD-INR forward premia) will be just 2%. In turn, this can put pressure on INR, both with higher domestic demand for USD, and a drop in fresh inflows into India,” said Narayan.
The narrowing interest rate differential could also impact currency carry trade. “There are a lot of moving parts. A lot will depend on how the RBI reacts to the actions taken by the Fed,” said Duggad .
India’s foreign exchange reserves fell by $7.5 billion to $572.7 billion for the week ended July 15, $70 billion lower than the record high of $642.4 billion seen on September 3, 2021.
The Fed’s actions could also amplify downside risks to earnings growth and hurt consumer confidence, with the possibility of higher inflation leading to demand destruction.
“Within India, lower-end consumption specifically has seen marked deterioration. Nevertheless, we expect cost pressures to ease in the second half of the year, which may partly offset the reduction in overall topline growth. Hence, we expect 4-5% EPS cuts to Nifty consensus earnings estimates for the next couple of years,” said Gohil.
According to Christopher Wood, global head of equity strategy at Jefferies, the only possible source of relief for Wall Street-correlated world stock markets, save for a Fed U-turn, would be a sign that inflation has peaked and is coming down sharply, which clearly is not the case yet. “A sharp decline in money supply growth has potentially alarming implications for the American economy going into 2023, unless the banking system comes to the rescue. But the lag effects of the previous monetary explosion means that inflation can remain high for a while longer even if the Fed sticks to its current hawkish line for longer,” Wood said in his recent weekly note Greed & Fear.