US interest rates: Will they, won't they... - Views on News from Equitymaster

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US interest rates: Will they, won't they...

Mar 26, 2004

American consumer, one of the key drivers of the global economy, has had an excellent run in recent times. Buoyed by one of the lowest interest rates in about four decades, he went about splurging and in the process drove the GDP of his nation to two successive quarters of record growth. Assets like stocks and houses also witnessed a lot of appreciation during the same period as liquidity created due to low interest rates and robust growth in GDP made investors turn towards these investment avenues. The fact that the stock markets were languishing at lower levels and there were a lot of value buys also helped. However, investors have a tendency to overdo things and rampant buying in the above mentioned assets have raised fears of another bubble as these avenues have already started looking overvalued. Infact, since the beginning of the year, the benchmark indices like the S&P 500 and the NASDAQ have already corrected by almost 5% and 10% respectively from the highs they reached in mid January. It is therefore being feared that such profligacy if not stopped, would ultimately lead to the bursting of the bubble and would plunge the country into recession.

Lower interest rates prevailing in the US markets is said to be one of the primary reason behind the current state of affairs. While the rates were essentially lowered to avoid the country from heading into recession a couple of years ago, the objective seems to be more than achieved as consumer demand has been pretty robust. But if more and more capital continues to be pumped into the system, law of diminishing returns, whereby the output grows at a slower pace is likely to set in, which would eventually retard growth and drive prices up, thus leading to inflation. However there seem to be no such worries currently on the inflation front. While inflation in the US markets is hovering at comfortable levels of 1%, asset markets such as stocks and real estate are sucking up the excess capital, thus leading to unsustainable price rises.

One of the primary ways in which this could be avoided is to raise the interest rates and thus slow down consumer demand and also force investor investment into less riskier securities such as longer-term bonds and other similar securities. Therefore, when the Fed decided to maintain the status quo on interest rates in its meeting earlier this month, eyebrows were raised and it was being felt that a rise in rates would have been a better option. However, there was a different factor at play here and this had to do with the fact that the growth in employment has been sluggish in the US economy. Owing to gains in productivity and outsourcing of jobs, employee demand has failed to pick up and if Fed were to raise rates further, there are fears that slowdown in fresh investments would further dim job growth prospects. And with elections round the corner, such a course of action would be detriment to the prospects of the incumbent government.

The Fed thus seems to be stuck in a catch-22 situation. However, it is common knowledge that decisions, which are in the long-term interest of the country, have to be given precedence over the ones, which alleviate the short-term pain. But the Fed seems to have digressed from this notion if its latest move is indication. Considering the fact that the Fed diktat has global implications, it won't be long before sanity prevails.

With increasing integration of India with the global markets, any such decision is likely to have an impact on the Indian markets as well. While the appreciation in the Indian stock markets did have a fundamental feel to it, one cannot ignore the role Foreign Institutional Investors (FIIs) have played in helping the indices scale new heights. Taking advantage of the interest rate arbitrage, these institutions have pumped money into the Indian markets and will continue to do so as long the spread is comfortably high. But once rates start rising in the US markets (thus making US assets more attractive), a stock market which still accounts for only 0.8% of the total market cap of all the major indices in the world is likely to drop faster from the good books of these FIIs and this might result in a rapid fall in stock prices.

Therefore, an average investor has to have this in mind and make his investment decisions accordingly. As the Indian economy gets further integrated with the global economy, movement in US interest rates will start playing a major role in the movement of the Indian economy and consequently the Indian stock markets. Instead of getting swayed away by speculation, he should see whether the valuations look stretched from a medium term perspective and invest in only those companies that have a sound business model and management with a proven track record.

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