Why is the market falling post the Fed rate cut?

BL research Bureau

The Federal Reserve reduced the Fed funds rate by 25 basis points (bps), as widely expected by markets. But the commentary of Fed Chairman Jeremy Powell, after the Fed meeting threw a dampener on financial markets.

There was widespread expectations was that the Fed would be launching a rate cut cycle from August, with at least 75 bps cut in the Fed funds rate up to the end of the year, in order to help avoid recession in the US. But, the Fed Chairman made it clear that the rate cut was “mid-cycle adjustment to policy”, thus ruling out a series of rate cuts.

Also read:What does the Fed rate cut mean for Indian bond yields?

The Fed appears to have lowered rates this time due to the uncertainties to economic growth due to the ongoing trade tensions and lower than expected inflation. But as the FOMC statement said, US labour market remains strong and economic activity in the US has been rising at a moderate rate.

Against this background, the Fed is fair in saying that future rate cuts will be possible only if economic indicators deteriorate significantly.

Impact on stocks

There was violent reaction in the US market to the Fed Chairman’s statement ruling out a rate-cutting cycle. The Dow Jones Industrial Average and the S&P 500 lost over 1 per cent after the statement. But, this is not surprising since both the indices are trading close to their life-time highs and are up 15 and 18 per cent so far this year. Much of the gain over the last 2 months was predicated on a Fed rate cut ensuring continuing liquidity in markets.

Some valuation metrics in US are also flashing red, which does not bode too well for global markets. This is because trends in US equities tend to influence sentiment in other equity markets as well.

The Sensex and the Nifty have begun the session on a weak note, down over 1 per cent, in line with other global indices. The rate-cut by the Federal Reserve is important for all global markets because the impact it has on the foreign portfolio flows in to the country.

The ‘dollar carry trade’

The era of US interest rates being close to zero, and series of quantitative easing programmes where notes were printed to stimulate the economy, after the 2008 crisis, has given rise to ‘dollar carry trade’, wherein money is borrowed in dollars to invest in assets, including equity, across the globe.

It is important that rates in US continue to remain low in order to keep the global asset prices elevated.

If interest rates begin moving higher, that leads to deleveraging (wherein the loan taken with lower interest rates have to be repaid, which can be done by selling assets purchased with that money). This leads to global sell-off in financial markets, as was witnessed in the last quarter of 2018.

It can be argued that other central banks such as the European Central Bank, Bank of England and Bank of Japan are continuing their monetary easing and keeping rates near zero, and that can help equities. But it needs to be understood that almost 50 per cent of global investor money originates from the US, and hence the rates in US tend to have the largest impact on global portfolio flows.

Impact on rupee

The dollar index that tracks the movement of the dollar against 6 major currencies spiked up very sharply after the Fed’s statement, and is very close to the 100 mark. This is a sign that financial markets are ruling out further rate cut by the Fed and are getting ready for further volatility.

The dollar can strengthen further in the days ahead as the rates in US are far more lucrative compared to negative yields on bonds of other advanced economies. Further, with dollar being a safe haven asset, money tends to move in dollar-denominated assets in times of stress, away from riskier assets.

Rupee has not reacted too much to dollar strength, and is trading slightly down, around 69. But this event is likely to limit rupee’s strength to the 68-68.5 zone. A stronger dollar will apply downward pressure on the Indian currency and drag it towards the 70-70.5 zone.

But the relatively attractive real yields on Indian bonds is likely to sustain FPI flows in to Indian debt, thus providing support to the Indian rupee, keeping it in the 68-71 range for a while.

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