What 6% Fed rates could really mean for India?

10 Mar 2023 , 09:36 AM

It is already well documented that Powell and the FOMC have turned hawkish since the February FOMC meeting. The Fed testimony presented by Jerome Powell to the Senate Committee on Banking, only underlines this hawkish turn. This has two implications. Firstly, any rate cuts in 2023 are ruled out and rate cuts could continued for longer than originally expected. Secondly, the terminal rates could be higher than originally envisaged. Some large investment houses like Blackrock, USB and Citi have projected the US Fed interest rates to go as high as 6%; which is a full 125 basis points higher from the current levels.

Fed hawkishness has never been good news for India and that is clear from the magnitude of FPI outflows last year. Between October 2021 and June 2022, FPIs pulled out $34 billion from Indian equity markets. In January and February 2023, when the Fed turned hawkish once again, FPIs withdrew $4.21 billion from Indian equities. But that is not the only thing makes the risk higher for an emerging market like India. Let us first look at what exactly has triggered this debate in the context of Indian markets.

Indian yield curve inverts first time since 2015

On 08^th March 2023, the Indian yield curve inverted for the first time in 8 years. What does a yield curve inversion mean? The yield curve measures the relationship between yield and tenure. This yield curve normally has an upward slope since higher tenure bonds will carry higher yields compared to lower tenure bond. For example, a 10-year bond has more risk than a 1-year bond or 2-year bond and hence the yield of the longer bond should be higher. Since slope of yield curve and shifts are hard to measure, we use proxies, and one of the proxies is comparing the 364-day Treasury bill yield with the 10-year bond yields. On 08th March 2023, that spread went negative. 

The cut-off yield on the 364-day treasury bill rose above that of the benchmark 10-year bond on 08^th March 2023. While the 364-day notes quoted at a 7.48% yield, the 10-year benchmark bond traded at 7.455% yield. That was because there was more demand at the short end of the curve as compared to supply, while it was the other way round at the long end of the yield curve. This caused the inversion. Now, why is this inversion relevant? The 10-year bond yield has hovered between 7.30% and 7.46% since January 2023. However, during this period, the 364-day Treasury Bill yield has gone up from 6.91% to 7.48%. An inversion of the yield curve is a rare occurrence and is indicative of a slowing economy in the coming quarters. That has triggered this debate on the Fed rate impact on India.

The 6% US Fed rate scare

The first signs of the Fed rates ending up higher than usual were visible in the minutes of the February meeting. Subsequently, the Powell testimony almost confirms that the rate hikes are going to go on for longer than expected. Powell has now explicitly suggested that the terminal rates may end up in the range of 5.50% to 5.75% and even touch 6% in a worst-case scenario. Big names like Blackrock are now openly talking about a 6% terminal rate for the Fed rate, which is not good news. US real rates are already at a multi-year high and more rate hikes amidst tightening inflation will only make more funds flow towards the US. That is why, in a recent report UBS has pointed out that the Fed taking rates to 6% could leave an imprint on emerging markets, especially on markets like India.

But, why is India more sensitive?

For now, it is just a view expressed by broking houses like UBS, but they do have their reasoning in place. According to UBS, Indian inflation has two problems. Firstly, the core inflation is sticky at 6%. Secondly, there is a lot of broad inflation in India, in the sense that more than half the items in the core CPI basket have inflation of more than 5%. That only means that the RBI would continue to stay hawkish and enhanced hawkishness by the Fed would only make the RBI more vigilant on monetary policy. UBS has also pointed out that India happens to be one of the most sensitive markets to US rates, since FPI flows have a lot of incremental impact on Indian markets. Also, domestic flows may not remain strong if domestic rates continued to rise as that would also impact the SIP flows into MFs.

How much could 6% Fed rates have an impact on India?

UBS is of the view that 6% Fed rates could be a worry for India for several reasons. Here is why UBS wants India to be cautious.

• If the US raises the rates too fast and RBI is cautious, then there is the possibility that the spread between real rates in India and the US could actually start favouring the US. That is typically a recipe for capital outflows, especially the generic risk-off flows.

   

• In the last few years, the domestic investors like mutual funds, insurance companies and retail investors have been a counterweight, whenever FPIs have been net sellers. However, UBS feels that could have limits. Higher rates would put limits on the saving ability of households and that would impact flows into mutual fund SIPs. Overall, the domestic support for markets may not be too sustainable in a high interest scenario.

   

• Above all, a sharp spike in rates is also not a happy scene for corporate bottom lines. Q2 and Q3 of FY23 have seen visible pressure on profits from higher interest costs. Higher rates would not only depress profits but also push up the cost of capital; making it a double whammy for valuations of Indian companies.

But there is ample light at the end of the tunnel and that is the good part.

Let us not miss the positive side of the story

Despite specific concerns highlighted by UBS on the India story, there are some factors that would still work in India’s favour. Firstly, the relative valuation advantage that most of the Asian emerging markets enjoyed over India just one quarter ago, has diminished. That reduces the risk of EM flows preferring other markets over India. Secondly, it cannot be ignored that real GDP in India is slated to grow at 7% in FY23. 

Also, India will be the fastest growing large economy for the next two fiscal years and that should give comfort to a lot of global investors. Thirdly, the Indian stock markets have not been too vulnerable to rate hikes by the RBI. Despite the RBI raising rates by 250 bps since May 2022, the Nifty is up 4.02% during the same period.

But the real advantages are elsewhere. For instance, the PLI scheme promises to change the way India does business and the way Indian companies are likely to be valued. It is likely to take Indian manufacturing scale to a different level altogether. Also, there is still a lot of working capital slack in the books and companies can still improve profits through better inventory and receivables management. Yes, 6% Fed rates are a worry for India at a macro level. However, the good news is likely to outweigh the concerns.