The Federal Open Market Committee (FOMC) on 14th June 2017 announced a 25 basis points hike in the Fed rate. This takes the overall Fed rate to the range of 100-125 basis points. There was not much of a surprise element in the decision as the CME Fed Watch Tool was already indicating a 95% probability of a June rate hike one day before the meeting. Here is what we need to understand about the rate hike and its implications for markets in general and India in particular.
Jobs good, growth OK, but inflation still low…
This has always been the troika of factors that has driven the rate decision by the Fed. In the previous meeting in May 2017, the Fed had chosen to maintain status quo due to weak economic growth of just 0.7% in the first quarter ended March. However, the Fed now expects the GDP growth rate to get back to 2.2% by the end of the calendar year. Employment has been extremely favourable for a rate hike. In jobs parlance 5% unemployment is regarded as full employment. The figure of unemployment in the US is now getting closer to the 4% mark. Additionally, wages are also showing signs of rising. Inflation may be the one factor which is still below the benchmark target of 2%. In fact, for the year, the Fed is looking at a likely inflation rate of 1.7%, slightly lower than the 1.9% projected originally. This lower inflation has been largely driven by weak oil prices and tepid commodity demand. With the US shale flooding the market and Qatar in the midst of sanctions, the global oil prices are likely to stay low.
For the full year 2017, the Fed has maintained its guidance of 3 rate hikes. With one rate hike implemented in March this year and now one rate hike in June, there is room for one more rate hike in 2017. In fact, the CME Fed Watch Tool is assigning a high probability of the next rate hike happening in December 2017, with a rate hike in July almost ruled out. The Fed has also guided for 3 additional rate hikes in year 2018 but has maintained its long term target equilibrium Fed rate at 3%.
What the rate hike means for India and other EMs?
There may be some pressure of outflows from Indian debt as the yield spread between the US benchmark and the Indian benchmark is likely to narrow further. That could be put temporary pressure on Indian markets. However, over the medium term, the rate hike will be viewed positively. Firstly, a rate hike is a signal that the US economy is growing and Yellen is virtually guiding the US economy for growth and optimism. That is good for the Indian markets. Secondly, the phased hike in Fed rates is a signal that fiscal measures like tax cuts and infrastructure spending may be on the way. That can again have a positive demand pull impact on India. Broadly, the rate decision appears to be positive for India. The only takeaway is that the RBI may be averse to cutting rates in August.
The real story is about the tapering of the bond portfolio…
For the first time, the Fed has indicated that it may be closer to commencing the tapering of its massive bond portfolio. First a brief background! At the peak of the financial crisis in 2008, the Fed decided to infuse liquidity in the system by buying bonds from the markets. When the Fed buys bonds, these bonds pile up in the Fed portfolio and the liquidity gets introduced in the system. As the chart below indicates, during the 6 years between 2008 and 2014, the Fed bond portfolio expanded from $1 trillion to a whopping $4.5 trillion. Since 2014, of course, the Fed bond portfolio has been static at the current levels with just a few minor adjustments caused by interest reinvestments. The Fed has stopped fresh buying of bonds since 2014 but the redemptions are still being reinvested in bonds.
The chart above indicates the sharp rise in the Fed bond portfolio since 2008 and its flattening post 2014. For the first time, the Fed has indicated that the actual tapering of this bond portfolio may be closer than ever before. The taper is critical because it is the reverse of liquidity infusion. If the rally in global markets since 2009 was fuelled by the infusion of liquidity, it remains to be seen what happens when that liquidity is sucked out of the market.
What does this taper mean for India?
If you go by the experience of mid-2013, when the Fed had first mentioned the taper, there was a run on the Indian Rupee as well as Indian bonds. In fact the INR lost nearly 25% in less than 3 months while the bond markets saw FPI outflows to the tune of $14 billion. However, this time it is likely to be different. Firstly, the taper is likely to be gradual. The Fed will begin with absorption of $6 billion per month and gradually raise it in a phased manner to $30 billion per month in case of treasuries. In case of mortgage backed securities, it will gradually go up to $20 billion per month. This gradual tapering will give the Fed time to assess the impact. The Fed has also confirmed that while the bond portfolio will go below the current level, it will still be substantially higher than the pre-crisis levels.
For India, there are two key takeaways. First, the gradual tapering of the bond portfolio will not create any liquidity shocks in the system and the Fed will have ample time to react to any shocks. Secondly, the taper will lead to higher yields in US bonds and that may reduce the need for rate hikes in future. That may be the big positive takeaway for the Indian markets.