Ind-Ra: US Fed's Status Quo Creates Uncertainty, Will Keep Markets Volatile

The status quo maintained by the US Federal Reserve in interest rates and the associated statements early today create more uncertainty for the markets than the benefits of continuing low rates over the medium term, says India Ratings and Research (Ind-Ra). The markets, going by the correction in the two-year US treasury yields (17 September 2015 closing: 0.682% vs previous day closing: 0.813%) post the Fed announcement, were anticipating a rate hike with a dovish commentary.

Ind-Ra expects the Indian currency and debt markets to react positively to the development, but the markets could become edgy post the initial euphoria. While Ind-Ra continues to expect the Reserve Bank of India to reduce policy interest rates by 25bp on 29 September 2015 given the low inflation and the attractive real interest rates, the uncertainty factor may limit any aggressive reduction in the policy rates.

The US Fed indicated a possibility of a rate hike by end-December 2015, but the drivers of the decision have become ambiguous. While there were concerns highlighted on account of China, there was a reference to the fact that recent events do not weigh in beyond a point. The Fed's focus would be squarely on the path to inflation of 2% and a further improvement in labor markets, while continuously looking at developments in the financial markets. Given that the inflation expectations have been pared down from the July forecast and the labour improvement is not translating into wage increases yet, these indicators may not show the necessary improvements by the end of the year. This would mean that the argument to hike rates even by the end of this year could also be weak.

The Dollar Index weakened post the Fed's decision (down to 94.55 on 17 September 2015 from 95.42 on the previous day) which is a short-term positive for emerging market currencies including the rupee. Also, domestic macroeconomic fundamentals are improving (real GDP growth above 7%) and inflation is benign. Soft global commodity prices augur well for the current account and growth in India. We believe the rupee will show some strength but market uncertainty could start outweighing it once the initial euphoria settles in.

With the Federal Open Market Committee behind us, gilts are likely to register upbeat momentum driven by the expectation of softening policy rates. The benchmark 10-year G-Secs ended at 7.75% on Wednesday (currently down 3bp-4bp). Corporate bond spreads on the other hand would continue to track the health of corporates.

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