The Fed has prepared the world very well for a rate hike. In fact the market may have priced in a 25 basis points increase. So if the increase is 50 basis points, the reaction could be stunning, but a 25 basis points rise is not likely to have any great impact, says P V Subramanyam.
What could happen if the United States Federal Reserve increases its interest rates?
First, the theory, then let’s see what I think will happen. Soon the reality will hit you and a completely different scenario could emerge. Welcome to the amazing world of finance, currencies, interest rates, and the great human behaviour.
The caveat first: Nobody, repeat, nobody knows why the market goes up or down in any given day or week or month. There are just too many factors impacting the markets -- but even a person who has done economics for just one year will tell you, when demand is more, price goes up, when supply is more, price goes down. Having said that, all the movement in the indices from December 15 to 18, 2015, will be attributed to the Fed rate hike -- whether it happens or not. That is decided and final.
The Fed has prepared the world very well for a rate hike. In fact the market may have priced in a 25 basis points increase. So if the increase is 50 basis points, the reaction could be stunning, but a 25 basis points rise is not likely to have any great impact.
When one country increases interest rates, money will flow towards that country, and it will leave the countries where it is getting lower interest rates. Now wait a minute, people are getting eight per cent in India while the US rate is 0.75 pc and the Indian forward currency cover is say 5 pc per annum. So what are we talking about? Oh, safety -- the theory is that your money is safer in countries like USA, France, the UK, etc. so money should flow out of Emerging Markets (read: India) and go to a safe haven called the USA.
Well, in real life, we may see some outflow from the Indian bond market, but the impact is likely to be insignificant. However, if more people decide to withdraw, we could see pressure on our currencies. So the dollar may be headed to say 68/9 in the short run. However, seeing the potential pressure on the currency some people could be taking their money out just before the rate cut, but it is likely to be temporary.
The same thing could happen in the equity markets, too, but the amount of money in the debt markets is much higher. So the impact on the equity market may not be much. However, one caveat: if the other players, speculators, decide to sell anticipating this fall, then the fall could be greater. However, it is again likely to be minimised because of the eight million SIPs which will keep happening immaterial of the market levels.
Actually, what worries me is not the rate cut, but the fact that the US economy is doing well. This might attract some of the portfolio money or the P notes money to the US market. This will have an implication on our Sensex, Nifty, currency and market expectations.
Gold investors will find the situation a little tough. Gold does well only during a crisis situation, and once that is over gold has no ‘preserving’ properties. This will mean that gold will move around poor to very poor returns, but people will convince themselves that ‘gold will do well in the long run’.
Those in the debt market can expect the Indian central banker to slow down the rate at which he is reducing the interest rates. This will mean that there will be more public sector bonds issued. These bonds are being issued at about 7.5 pc pa tax free, and is a good rate to lock in your money for long periods of time. So be alert for such issues in which to invest.
I would not be brave enough to say ‘it is the end of the cheap money in the world’ – remember, Europe and Japan may not be in a hurry to increase interest rates. Well, not as of now at least.
So technically, all the bloated assets will have to deflate a little -- and give more respect to the currencies. So, asset bubbles will have to burst. Surprisingly, commodities did not participate in the currency-caused boom -- so there is no great implication there.
Cheap money in one country should have led to a currency crisis, right? However, the Fed was not the only banker who was creating more money. The American inflation got exported so some of the inflation will come back for them. The carry-trade of borrowing in the USA and investing in India had dramatically increased and it was being done by the Japanese too -- all this will of course go.
The interest rate increase will push the American economy a little harder -- and the Fed may not hike interest rates again. So if the Fed talk is dovish, the market may actually go up -- saying that there is no further hike coming. Remember, the market is about the future.
What are the implications for the common man? Actually, nothing. If you are afraid that the Fed rate hike is going to ruin your portfolio or create a huge opportunity for you to buy, you are likely to be disappointed. Remember the market ‘buys on rumours and sells on the event happening’. So the event of Fed hike happening it might actually see the market go up -- because people who have sold hoping that the market will fall will now come to buy. If the fall is not too much, the buying by short sellers could itself create a rally in the market!
So make sure that you continue your SIP, and that God is in Heaven, Narendra Modi is in Delhi, and the Indian markets will do what it has to do. Relax.
Image: Should you pray? Remember, the market is about the future, says the author. Photograph: Kim Kyung-Hoon/Reuters.
P V Subramanyam is a chartered accountant and financial trainer from Mumbai.