What’s in Store for Indian Markets from US Fed Tapering and Rate Hike?

BUDGET 2022

India has been one of the biggest beneficiaries of FII money over the past one and half years. Rate hikes could trigger an outflow for greener pastures.

After having a dream run over the past one and half years, markets across the world are now showing signs of nervousness. While the US Federal Reserve had indicated about the tapering programme along with interest rate hikes that will be done during this year in phases, and even the financial markets discounting them, the spurt in Covid-19 cases have once again unsettled the applecart.

There is a fear that a liquidity crisis could surface even as the US Central Bank continues sucking liquidity from the system.

After the first Coronavirus wave hit the world, the US Federal Reserve flushed the system with liquidity by buying bonds and securities at a rate of USD 120 billion per month. The money was used to stabilise the system and increase employment. The US Government also began giving unemployment benefits to its citizens as companies began to shut shop and lay its employees. What this did was that the money began to pour into the equity markets locally and in the emerging markets including India as people had money in their hands and looked for avenues to make more out of it through investments.

India was one of the biggest beneficiaries of this money as the Foreign Institutional Investors (FIIs) started investing in the Indian equities. The domestic markets were also supported by growth in the number of retail investors who became a part of this upswing and minted good money. The year ended with Nifty50 – a benchmark NSE index with top 50 listed companies in terms of their market capitalisation – settling at 20 per cent gains in 2021 over the previous year. This is notwithstanding the losses made by financial markets in December which was a very volatile month.

While the valuations soared, it was always about time that the markets would see correction. Market observers have been warning the investors that the days of easy money are now behind us.

What is spooking the markets?

As stated earlier in this article, the fact that the honeymoon period is over was a given. What is ringing the alarm bell now is the US tapering (has already begun) which will be followed by interest rate hikes in the world’s largest economy. Let us understand how it impacts emerging markets including India.

The US Fed has continued to pump money in the economy since 2020 when the first wave hit its shore. For extending it for more than a year (at USD 120 bn per month), the Central Bank indicated that the intended objectives had been achieved and it will start reducing the extent of bond purchases.

It began the tapering exercise in November 2021 by reducing the monthly pace of treasury purchases by USD 10 billion and of mortgage-backed securities purchases by USD 5 billion. While the initial intent was to finish tapering by the middle of 2022, with rising inflation, it is being said that the process could be expedited and the US Fed could complete it even sooner.

It will simultaneously increase interest rates at least four times this year and by 25 bps from the nearly zero rate regime currently. The latest Covid-19 variant could only further aggravate the inflation situation and many analysts are now expecting more hikes during the year.

A media report quoted a Goldman Sachs analysis saying that the US Fed could adopt a more aggressive stance of rate hikes in the wake of growing inflation and Omicron. It further said that the hikes could be implemented in March, June, September and December.

In US the inflation is highest in 40 years, and that is causing a lot of distress. A higher rate regime will increase the cost of lending and soften prices and that is how Central Banks across the world control inflation.

When that starts, the institutional investors will start pulling out their investments in the emerging markets for the greener pastures back home. The reduction of liquidity and higher interest rates could act as a double blow for the emerging markets as well while prolonging the economic recovery.

The India Scenario

In the week gone by, Indian markets witnessed a blood bath with benchmark indices BSE Sensex and the NSE Nifty50 correcting by over 4 per cent over the week. Out of the five trading days, the domestic equity markets fell on four occasions.

Indian markets which are largely led by the US markets are expected to feel the heat as well, at least, initially. The FIIs sold Indian equities worth over Rs 12,000 crore in the last two trading session in the previous week. This is what is worrying the domestic markets. And more rate hikes or even speculations around it could only keep them on the edge.

Even the Indian Central Bank has expressed concerns over the growing inflation situation here. It has also spelt out measures to reduce access liquidity though the Reserve Bank of India (RBI) has been maintaining that it will keep an accommodative stance for as long as necessary as far as the key policy rates are concerned.

Inflation is a real problem and with Omicron in picture, things could worsen for the Indian economy as well. There is a fear that the policy normalisation can be pushed back further if the cases continue to grow. That would lead to spiralling of inflation in the near to medium term. And if RBI adopts a similar stance like its US peer, a liquidity crisis could potentially weaken the ongoing recovery.

It is a double-edged sword and it will be interesting to see what course RBI takes in its February Monetary Policy Committee (MPC) meeting – its first in 2022.    

Indian Financial Markets

However, the bright side is the ever growing retail investor base in the country which has acted as a major support for the local markets on a number of occasions. India has added several million retail investors in 2021 on the back of the booming Initial Public Offering (IPO) market. More than five dozen companies raised over 1 lakh cr from the primary markets in the previous year. The investors and companies benefitted, alike, from the public issues, such has been the euphoria.

Moreover, Union Budget 2022 is also being closely looked at and expectation of a growth oriented budget is there, similar to the last time. We could see specific announcements for those sectors which are seen as high growth engines.

Over the last two years, the government has looked inwards and focused on making India a manufacturing hub for the world. The launch of Production Linked Incentive schemes (PLI) schemes is a step in that direction. Its implementation and success, although, will be a big wall to climb. But these measures will only strengthen the economy, going forward and benefit companies with strong fundamentals. While the global factors will impact how the markets move in India, its own local factors are now strong enough to hold it in case of disruptions in the external factors. Investors must remain cautious and see how things unfold over the next 2-3 months.

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