While Yellen Hikes Rates, Markets Stop Short of Yelling. But for How Long? - The 5 Minute WrapUp by Equitymaster
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While Yellen Hikes Rates, Markets Stop Short of Yelling. But for How Long?

Dec 15, 2016

In this issue:
» Half of India's households used to saving cash at home
» Demonetisation throws India's knitwear capital out of gear
» Roundup of the stock markets
» ...and more!
Rahul Shah, Co-Head of Research

It has finally happened.

After almost a year of dithering, the US Federal Reserve on Wednesday raised its target federal funds rate by 0.25% to between 0.50% and 0.75%.

And the Indian market has taken it like a champ. With the BSE Sensex opening almost flat today, it has hardly betrayed signs of nervousness. This calm reaction may have to do with the fact that a rate hike was widely expected.

But do not take the market's initial serenity as a sign of things to come. What many perhaps did not see coming was a robust increase in the Fed's appetite to raise rates going forward.

The Fed's outlook is now for three more 0.25% hikes in the coming year. And then another three increases in both 2018 and 2019. This would mean nine rates hikes over the next three years before the rate levels off at a long run 'normal' of 3%.

One catalyst for this has been Donald Trump. In the works are said to be plans for simultaneous rounds of tax cuts and increased spending on infrastructure by the president elect. This has caused US Fed policymakers to shift their outlook to one of slightly faster growth, lower unemployment, and inflation just under the Fed's 2% target.

So while markets have reacted calmly for now, a new risk may be emerging: that the Fed raises interest rates too fast, too soon going forward. And such an eventuality could have a number of ramifications, including a huge crash in the US bond market and wild swings in stock markets around the world.

Kim Iskyan, editor of the Truewealth Asian Investment Daily, highlighted this possibility in Vivek Kaul's Diary recently. In fact, he went as far as to compare it to the large-scale rout of the US bond market in 1994 and the resultant panic:

  • ...if rates climb suddenly and without warning, the resulting bond market crash may make 1994 seem like a gentle swell compared to the coming tsunami.

    All the suppressed financial tension built up since 2008 could unwind in a tornado of falling bond prices as fund managers bail out of their rapidly crashing bonds.

    Remember, when rates change from 6 percent to 8 percent), it's only a 33 percent change. But, when rates change from 0.50 percent to 2 percent, rates have quadrupled!

    And if that happens quickly... it could cause another bond market crisis.

    ...the bond market is looking like an enormous bubble waiting to be popped. The Fed could provide the explosive pin necessary to pop it.

And when bubbles pop, as we've seen time and again, panic is quick to ensue. Who knows how the falling dominoes would affect financial markets and stocks?

To be sure, all of this for now remains a mere possibility of how things could pan out in the coming year and beyond. But it's a very real possibility.

Smart investors will build this into their calculations by preparing for all possibilities. And there's no better way to do this than by investing a portion of money in safe blue-chip stocks that have the potential to deliver stable and consistent returns through the thick and thin of financial markets.

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02:30 Chart of the day

Today's chart of the day is perhaps the reason why there are serpentine queues in front of banks and ATMs these days. As the chart highlights, nearly half of the total households in the country are used to saving cash at home. And with Modi rendering old high denomination notes worthless, there has been a mad scramble to get them exchanged at the very first opportunity.

The reason for saving cash at home is simple. There is no substitute for it in terms of carrying out the various transactions. And the one that's visible on the horizon viz. digital transactions, is nowhere close to reaching every nook and cranny in the country. The infrastructure requirement for build up a pan India digital platform is huge and it could easily be few years before we could see some significant changes on this front. And even if it is available, what about people's psyche? Is it going to change any time soon?

We don't think so. Modi has indeed tried to take the horse to the water in one swift move. But will the horse eventually end up drinking the water? In fact, is there enough water available for everyone to drink? Well, these are questions that only time will be able to answer in our view.

Here's Why Demonetisation is Causing Serpentine Queues Outside Banks


Apart from causing serpentine queues, demonetisation has also disturbed the equilibrium for a lot of businesses relying on cash. And perhaps nowhere is this problem more acute than Tirupur, the knitwear capital of the country. As a leading daily highlights, demonetisation has thrown businesses here totally out of gear. Making matters worse is the fact that this is the time of the year when this textile hub is a beehive of activity on account of orders pouring from outside.

There are stories ranging right from a factory owner worried about whether his employees will even turn up on account of delayed payment to how another owner is cancelling orders just because he doesn't have enough cash to hire fresh hands. Not to forget the massive loss of productivity by way of standing in queues for cash withdrawals and playing truant at work.

Of course, there are many Tirupur like stories all across the country where businesses are taking a hit and how it is percolating down to other areas of the economy.

And if you thought this pain will last for a mere 50 days as was promised, you are wrong. As Vivek Kaul writes in a recent essay:

  • Without enough paper money in the economy, people can't carry out transactions and the economy comes to a standstill. This is what is happening right now all-across the country. Mobile phone sales are down. People aren't buying two-wheelers. Restaurants and malls are deserted. And normal taxis are not getting enough business.

    The farming economy has slowed down tremendously. Daily wage workers like plumbers and electricians are not getting enough work. For more examples, you can open any newspaper and there will be enough stories there. Generally, business is slow.

    And that being the case, it will take some time for the economy to recover.

    Indeed. The damage is going to be more long lasting than what was announced earlier. Let's just hope the long term benefits more than compensate for this short term pain.

The Indian markets seem to have taken the Fed rate hike in their stride as the indices are up marginally at the time of writing. The Sensex is up 25 points currently. Gains are also being seen in the Small as well as the Mid Cap indices. Amongst sectors, IT stocks are finding favour.

4:56 Investment mantra of the day

"We don't have to be smarter than the rest. We have to be more disciplined than the rest." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst).

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