Fed rate rise: 3 scenarios for Indian equity markets

All eyes on US central bank's meeting today on the key decision of whether to raise its policy rate

The beginning of the end of 'quantitative easing' (QE) in the US began in mid-2014, when the markets were jittery over the Federal Reserve's actions and its implications on the market, on what is nowtermed ‘tapering tantrums’.

The Fed was expected to slowly cut the amount of liquidity it was pumping into the system. Since most of the liquidity was diverted to financial assets, the markets were jittery because their lifeline, supply of money, would then be cut.

The Fed did stop QE in October 2014 but after the initial reaction, equity markets touched new highs, despite no liquidity influx. However, while it stopped QE, the Fed kept borrowing rates at zero. So, money was available off the tap, without cost. Though the official flow through QE was not available for the financial markets, ‘free money’ through the borrowing route was.

This access is now being threatened and keeping the markets worried. Economists and analysts are divided on whether the Fed will increase interest rates. The International Monetary Fund (IMF) has said it should not, given the turmoil in global markets, especially after the devaluation by China.

Raising of interest rates means all those who have been using ‘free money’ and those who intended to will have to pay for it. Investors who have used and deployed it in emerging markets have a built-in cost, the hedging cost of currency fluctuation. To earn a reasonable return, they have to first overcome the cost of hedging before they turn profitable.

If interest rates in the US rise, it signals that the country’s economy is doing well and investors would rather bet on the US markets than the riskier emerging markets (EMs), since they save on the cost of hedging.

So, the big question for the markets is how foreign investors will react on Friday, once all are clear on what the Fed intends to do. There are three possible outcomes of the Federal Reserve meeting. A rate rise will be proposed or there will be none and no clarity on future ones or status quo but with a timeline for future rises. Let’s take each possibility separately and understand how Indian markets might react.

If Fed increases rates
Impulsive reaction would be for foreign investors to withdraw money, leading to a fresh round of selling. But, nearly $3 billion of funds have already been withdrawn from Indian markets, apart from other EMs. While most of the money withdrawn has been termed ‘hot’ or short-term money, there is still enough residing in the markets and can leave, depending on the rise.

The government’s statement of being ready for any eventuality suggests they expect more money to be withdrawn from the markets and have stored foreign exchange reserves to meet this. Reserve Bank governor Raghuram Rajan has been resisting the call to reduce interest rates in India and is waiting for the Fed to make the first move.

Any action from the Fed will build pressure on RBI during the latter's September 29 policy meet. BofA-ML, in a report on the impact of a Fed rate rise, says if the latter happens, it is likely Rajan will cut the repo rate by 25 basis points.

If Fed maintains status quo
If the Fed succumbs to market pressure and decides to not raise rates, global equity markets might rebound. If the Fed does not give a clear deadline or indication of when it wants to raise rates, we could see a bigger rally.

If Fed gives timeline
The fall might be slow initially, as investors will get time to exit. But, action by the Indian central bank in terms of reducing interest rates can stall the outgo, as fund managers will get time to plan their action. In such a case, too, the spotlight will be on the RBI governor.