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Fed Rate Hike Impact On Equity, Likely Trajectory & Latest News

05 August 20226 mins read by Angel One
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The 2-day meeting of the Federal Open Market Committee (FOMC) concluded with a 25 basis point rate hike. This takes the Fed rate level to a range of 0.75%-1.00%. The indications were already there. In fact, over the last couple of weeks, the probability of a rate hike in March (as implied by the Fed Funds Futures) had shot up from 35% to almost 95%. It may be recollected that the Fed had first hiked rates in December 2015 after a gap of almost 9 years. The second rate hike of 25 bps came a full 1 year later in December 2016. Comparatively, the third rate hike has come within a gap of just 3 months. Additionally, the Fed has also hinted at a minimum of two more rate hikes during the calendar year 2017. This is largely along market expectations and hence it would qualify as a more benign approach to rates by the Fed.

The macro justifications for a rate hike were always there…

Over the couple of years, the Fed has consistently maintained its 3-pronged justification for rate hikes consisting of consumer spending, inflation and full employment. Most of these macros have turned robust and therefore a rate hike was perfectly justified. Consumer inflation that had touched a low of 0% in early 2015 in the light of the sharp fall in oil prices has moved towards the 2% mark on a sustainable basis. This 2% sustained inflation has been the cut-off for the Fed to sustain rate hikes. With oil stable and commodities getting expensive, inflation could stay above the 2% mark. Secondly, the US has already been at near-full employment for quite some time. Full employment is defined as an unemployment ratio of less than 5%. What has changed in the last few months is that wages have also shown an up-tick. That has been a strong justification for a rate hike. Lastly, the consumer spending is expected to sharply pick up in the aftermath of the fiscal policy thrust that Trump is expected to announce. In his election campaign, Trump had hinted at tax cuts for corporates and individuals and a massive investment of $1 trillion in infrastructure. Both these were expected to trigger off a virtuous cycle of spending and demand in the US.

How is the trajectory of rates likely to be?

While the 25 basis points rate hike by the Fed was already anticipated by the global markets, what they were really hoping for was a calibrated approach to future rate hikes. That is again something the Fed has managed to achieve. In fact, a clear idea of the trajectory of rates can be gleaned from the median growth, employment and inflation projections for the next 2 years. The median GDP growth for the next 2 years is in the range of 1.9-2.0%, while the median inflation is likely to be 2% for the next 2 years. Unemployment at 4.5% will be in the comfort zone. What this indicates is that while there will be a turnaround in growth and inflation, it will be gradual and there is no risk of runaway inflation. That surely makes a case for a calibrated rate hike during the current year. In the FOMC speech on March 15th, Janet Yellen has summed up the outlook for rates aptly, “While there is a strong case for higher Federal Funds rate to maintain the economy on an even keel, the Fed Funds rate is likely to stabilize at relatively lower levels compared to the previous decades.” This signals that, at best, there could be 1-2 rate hikes of 25 basis points during the current calendar year. In fact, that is what the Fed Fund probabilities are also indicating.

What does the Fed Funds rate mean for equity markets globally?

Global markets have generally been worried about rate hikes by the US after the experience of December 2015. In the aftermath of the rate hike, global equity markets lost nearly $12 trillion in the next couple of months. However, that was the global adjustment to a new normal. That is unlikely to repeat and equity reaction should actually be positive for this rate hike. A rate hike by the US Fed basically indicates that the US economy is robust and growth and spending is coming back in a big way. Being the largest economy in the world with a GDP of nearly $18 trillion, a recovery in the US spells good times for most economies in the world. So while bond yields will move up and bond prices will go down, equities will have reason to celebrate. Moderate interest rates supported by robust growth are a much better case for equities than weak growth supported by near-zero interest rates. That will be apparent in the coming months. This could be an interesting data point for India as the Nifty is already at a new high after the thumping BJP win in the UP elections.

How equities react to Fed rate hike: An empirical understanding…

To get a better perspective of the likely impact of the Fed rate hike on equities, let us look at empirical evidence. In fact, since the current rate hike cycle began in December 2015, the US S&P Index is actually up 15%. Even the Indian markets are at a new high. Back in 2004-05, the Fed raised the rates on 17 occasions and took the Fed funds rate from 1% to 5.25%. During this period, the S&P Index was up by 12%. On the contrary, between September 2007 when the sub-prime crisis broke out and the Lehman fallout in late 2008, rates were cut down to almost zero levels but the S&P index plunged by 40%. Earlier, between 1987 and 1989, the Fed hiked rates 27 times but the index ended 26% higher even after considering the infamous “Black Monday” in October 1987. Even in 1994-95, the Fed increased rates by nearly 300 basis points but the stocks ended up by nearly 20%. So the empirical evidence points strongly towards a positive correlation between Fed rates and the equity index.

So, it could eventually be good news for Indian equities. The only question is whether the reduced rate differential would lead to FPI outflows, especially in the debt markets. That appears to be unlikely considering the strength of the rupee and the robustness of the Indian economy. What could, however, happen is that the RBI may be inclined to hold rates in April and in the month of June too! That is something the financial markets need to be prepared for.


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