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The Fed and the Indian stock markets - Views on News from Equitymaster
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  • Aug 23, 2000

    The Fed and the Indian stock markets

    The bulls are back and the markets are on a roll. With the US Fed having decided to leave rates unchanged, the bulls will get yet another shot in the arm. But, in the first place, how do US interest rates affect domestic stock markets?

    By opening up its shores for international trade and investment, India's integration into the world economy was but an eventuality. The US factor comes in as the US Dollar is the only truly international currency. Most of our trade and capital flows are denominated in US Dollars and therefore a keen interest in the currency and the determinants of its value (interest rates among other factors). Another factor that leads us to track US interest rates is the fact that US stock markets set the benchmark for valuation of technology stocks.

    Let's first look at the factors that affect the stock markets directly. The US economy has been on a roll over the last decade largely due to a revolution in technological developments. The stock markets as a result of the unprecedented growth have been booming. The Fed, in order to curb the excesses in the economy, which have already given rise to inflationary pressures, has raised rates on five occasions in recent months. Persistently rising interest rates do affect stock market valuations and as the US is serving as the benchmark, any downward revision in valuations is bound to reflect in domestic markets. Further to this losses in stock markets could trigger redemption pressures on foreign funds, a number of which have an exposure to domestic (Indian) markets.

    Higher interest rates in the US also imply that US investors would demand a higher return (as opportunity cost is higher). This could lead to a slowdown in fresh inflows into the Indian markets, as more funds would be retained in the relatively higher yielding US markets.

    The other impact that US interest rates have is on the value of the domestic currency (which in recent weeks has been very volatile). Rising US rates would imply a stronger US Dollar (i.e. a depreciation in the value of the Rupee). This would adversely affect companies/government with unhedged foreign currency exposure. It would also correspond to a higher cost of imports. However, a modest depreciation in the value of the currency is not considered to be a negative as there are benefits in terms of an enhanced competitiveness in the export markets. The fallout of such an appreciation/depreciation in the value of the Rupee will impact the stock markets as it affects both the profitability of the companies and the flow of funds.

    The Fed's decision to leave rates unchanged is a blessing for the short rally that we have witnessed in the domestic markets. Nevertheless the continuity of the rally would also depend on several other factors. Two factors, as mentioned in our article have the potential to derail the rally - the tension in Kashmir and a potential hike in diesel prices.



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