“Just because we removed the word patient from our statement…doesn’t mean we will be impatient.” This is classic Fed talk. While signaling confidence in the economic recovery and inflation climbing back up to their 2 percent target in the long run, US Federal Reserve Chairwoman Janet Yellen gave no clear signals about the timing of the first rate hike. Looking at the price action in US equities and 10 year yields coupled with the steep sell-off in the US Dollar, my best guess is that a June hike is off the table.
The FOMC has placed itself in a position of vigilance and not action, thus letting the market rally continue and supporting a revised expectation for monetary policy normalization to begin late this year or early 2016. The Fed characterized GDP growth as having “moderated somewhat” and is no longer expanding at a “solid pace.” The Fed specifically pointed to weaker exports growth.
The Fed removed the word patience from the policy statement consistent with its desire to transition from time dependence to data dependence. Expectations for lift-off indicated by the “dots chart” were significantly lowered to a level more consistent with Fed Funds futures. Further, the Fed stated that a rate hike remains unlikely at the April FOMC meeting. The Fed lowered its forecasts for real GDP growth and inflation over the 2015-17 span, and slightly downwardly adjusted its long-term range for the unemployment rate from 5.2-5.5 percent to 5.0-5.2 percent.
Fed impact on India: structural bull market intact but requires ‘patience’
There has been a huge outflow of funds out of the US into Europe in the first quarter of 2015. According to EPFR, there has been a record $33.6 billion outflow from US equities and $35.6 billion inflow into European equities. There is a good chance of US equities witnessing strong buying after trading with a slight downtrend over the past month. If the US rally is sustained over the next few weeks, the Indian equity market will touch an all time high. But over the next six months, I expect a healthy consolidation and expect the Nifty to trade between 8200-8600. There has not been an earnings uptick as many had believed and there is a good possibility of EPS downgrades for next year. However, each dip is a great buying opportunity. The strategy should still be to remain overweight on rate sensitive and operating leverage plays. Quality autos, banks, cement and oil (as a reform play) are great areas to park money on corrections.
Rajan must ease faster than consensus
As following the CPI print of 5.4 percent in February, the consensus view is that CPI will consistently undershoot RBI’s 6 percent target through 2015 and average 5% in FY16 according to Citibank. While monsoon is a risk factor to these forecasts, the softer inflation readings should continue on account of lower commodity prices, moderate minimum support price (MSP) hikes and a deceleration in rural wages. Growth figures are nowhere close to flattering given the equity valuations the markets are commanding. Industrial production continued to expand at a moderate pace of 2.6 percent year on year in January as compared to a revised growth of 3.2 percent last month. On a sectoral basis, mining and consumer goods output contracted by 2 percent and 1.9 percent respectively in January while electricity and manufacturing output rose by a meager 2.5 percent and 2.8 percent respectively. Ongoing economic reforms and de-bottlenecking of investments will of course add to our growth rate in coming quarters but this must be accompanied by a large fall in the cost of capital. Negative yields made up 16 percent of the JPMorgan Global Government Bond Index following massive bond buying programs by the ECB and the Bank of Japan—against this backdrop, I see no reason why Indian bond yields should not fall to 4-5 percent in two years. Both crude benchmarks—WTI and Brent, are set to test their recent multi year lows with no visible catalysts for a sustained V shaped recovery. This alone should be reason enough for Rajan to go out and ease 50-75 basis points more than market consensus without the fear of inflation climbing back up.
Indian Rupee outperformer
The biggest measure of confidence in the Indian economy can be gauged by the price action in the USD/INR. While the US Dollar Index has rallied from 82 to 98 since last March, the Indian Rupee has held ground and outperformed emerging market currencies. Further, Yellen did refer to the recent greenback strength as a negative for the US economy thus sending the US Dollar index down 2 percent. We should expect the USD index to trend lower over the next few months back to 90-95 levels. We know the RBI are buyers at around 60-62 to recoup their reserves but an appreciating would support the interest rate easing cycle and if Rajan eases faster than market consensus. A sharp fall in the Rupee’s value against the USD should not be one of his major concerns.
There is a pessimistic camp: good news for bulls
Crowded trades and consensus economic views almost always wrong. Thus, what’s comforting is that there are influential market participants and policymakers extremely vary of the Fed’s tightening timeline. Speaking in Mumbai on Tuesday, IMF head Christine Lagarde said US rate increases could induce yet another round of the Fed induced ‘’taper tantrum’’ in emerging markets. She expressed her concern over the ‘’spillover effects’’ of premature tightening and warned that events of last summer were not ‘’a one off event’’.
The world’s biggest hedge fund manager Ray Dalio of Bridgewater Associates compared the financial conditions today to those in 1937 in a recent note to clients. He reminded investors that eight years after the 1929 stock market crisis and at the end of four years of money printing, premature tightening by the Fed led to a one-third slump in the Dow Jones Industrial Average in 1937 and the sell-off continued into the following year. “We don’t know — nor does the Fed know — exactly how much tightening will knock over the apple cart…what we do hope the Fed knows, which we don’t know, is how exactly it will fix things if it knocks it over. We hope that they know that before they make a move that could knock over the apple cart.”
Are we asking the right question?
The market is asking whether the US economy can handle a 25 basis points increase in interest rates. That to my mind is really an insignificant question. Because it clearly can. Historically speaking, we will most likely see a 2-3 percent drop in equity prices post the hike decision but that dip will be bought into. The US economy has enough steam despite slower than expected retail sales data and wage growth to absorb a 25 basis point hike after almost six years of near zero interest rates. The key question is whether the US economy can grow fast enough to handle the federal funds rate at 1.25-1.5 percent by end 2016 assuming the rate hike cycle begins in September. The biggest risk to global markets is not the normalization of US monetary policy itself but the possible event that the US Fed has to go back into easing mode. In that case, financial markets will lose all faith in the efficacy of unconventional monetary easing policies and central banks. More importantly, this crash won’t be an isolated event in the US. We have the European and Japanese markets rallying on the same policies followed by the US Fed and they will not be spared from capitulation. The whole definition of the risk on/risk off move would change—more QE would not lead to equities rallying and bond yields compressing. It would be the exact opposite. But the above would be a fat tail-risk event and a rational analyst would put assign an extremely low probability value on these outcomes playing out. The Yellen led US Fed clearly realizes that the risks of premature tightening far outweigh the risks of prolonging its easy money policies.
One can argue whether Yellen was hawkish or dovish in her press conference. But referring to equity valuations being ‘’not outside of historical ranges’’, she certainly doesn’t want the market to turn bearish as yet.