If the Fed hikes rates, some foreign investors are expected to book profit in their holdings in Indian shares and bonds; they will likely repatriate funds back to the US, where buying high interest rate bearing bonds will become an attractive bet.
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.
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.
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.
The impact of a rate hike in the US on India will be limited because of strong fundamentals, In 2013, India saw $12 billion in outflows from May to September due to US rate hike worries. A record high current account deficit, double-digit inflation and record-low rupee led to large-scale destruction of shareholders’ wealth back then.
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.