US Fed rate hike decision: Likely scenarios for India

The next two weeks will see a lot of high-volatility trading across financial markets. The ECB (European Central Bank) has come through with an easy money policy, which has, however, disappointed markets, which were hoping for even easier terms. The US Federal Reserve is expected to raise its policy rate for the first time in many years.

This divergent set of actions will impact forex rates. In turn that will alter trading patterns between countries, as the relative value of goods and services change. It might change the assessments of global GDP growth through the next financial year. The markets are already discounting such expectations.

There will be turmoil until a new equilibrium is reached. The expectations as of now is that the dollar will strengthen if the so-called Fed Funds rate is hiked. This dollar strengthening is likely for several reasons. The dollar will attract more inflows since bond yields will rise in tandem, with the policy rate hike and simple supply-demand will lead to upwards pressure on the dollar.

The interest rate parity equation will also change in favour of a stronger dollar if the Fed does hike. The dollar (or any currency) plus interest yield in that currency should equal the euro (or any other currency) plus interest yield for a comparable instrument in the same time period. The interest yield rises on the dollar and it falls on the euro due to central bank actions. So, the dollar should get stronger to compensate.

Of course, the markets can do surprising things. For example, traders have been betting on a 25 basis point hike in the Fed Fund rate. Traders have already been disappointed by the fact that the ECB has not eased money supply as much as hoped for. As a result, the euro has strengthened a bit because traders now anticipate that the differential between interest rates will not be quite so wide.

The Fed could surprise by not raising rates, or by raising rates more than expected. The first decision - to stay with status quo - would lead to the dollar falling. The second decision would lead to the dollar spiking up sharply. There could also be unusual market action if the Fed does rate rates as expected but gives unexpected guidance.

In the last two weeks of December and early January as well, we often see reduced trading volumes. People go on holiday and this is financial year-ending for many FIIs. Volume reductions often leads to higher volatility. In this instance, the volumes are likely to be higher but the volatility will also be higher.

The dollar/rupee movements and the impact on Indian stocks will probably be in line with moves in other markets. If the Fed hikes the rate, the rupee will fall. There will also be accelerated selling of Indian stocks (the FIIs are already net sellers of Indian equity in this financial year). If the Fed doesn't hike, the dollar will harden and there will be some bullish impact on Indian stocks.

This could be a good situation to consider dabbling in options. Long strangles on the Nifty may gain if there's a big move in any direction. Time decay favours option sellers, however. The Fed action will impact only after December 16 when relatively few sessions are left till expiry. The chances of the Fed not hiking is low so a trader may take unequal positions with fewer long calls than long puts. Similarly, long strangles with long dollar/rupee calls (these gain if the rupee dips in value) and long dollar/rupee puts (which gain if the rupee strengthens) could be considered. Again, expiry favours sellers of forex options.

The author is a technical and equity analyst