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Fed rates: Having an impact

Dec 10, 2003

The US Federal Reserve (the Fed), in its Federal Open Committee Meeting held yesterday, decided to keep the Fed funds' rate at its lowest since the last 45-years. While this move has not surprised many, let us discuss what implications does this have for the US economy and the global stock markets, including India.

As seen in the graph above, the Fed funds' rate has been on the steady decline since December 2000 (currently it stands at 1%, the lowest in the past 45 years). This has been a result of the Fed trying to kick start economic growth post the slowdown that started in early 2000. While the economy is showing signs of a turnaround, how sustainable would this be is still questionable. The US stock markets have been poured with a slew of positive reports from the labour, manufacturing and consumer markets and this has impacted the way the stock markets have moved in recent times. This has had a spill over effect on other markets as well, be it the Nikkei, the FTSE or the Dax.

Amidst all these positive reports, it has to be remembered that the key growth engine for the US economy has been the US consumer. The steady fall in interest rates has helped consumers to borrow more (housing, cars and personal) and as a result, demand has been on the healthier side. However, core issues like excess inventory and employment generation remains areas of concern for the Fed. Corporates have been downsizing payrolls over the last three years with threat of outsourcing also adding to the woes. While opinions vary about the strong GDP growth numbers in the last two quarters, it is too early to arrive at a conclusion.

Now, what implications does this movement in the Fed funds rate have on the Indian indices? One important factor aiding the current rally in the Indian equity markets (the BSE-Sensex has gained around 55% since January 2003) and that in other emerging nations is the rising levels of foreign institutional investments (FIIs). And the main attraction, apart from the obvious faster rate of growth has been lack of attractive return in US markets (both debt and equity). Though equity markets have risen in the recent past, there are apprehensions about current valuations. Therefore, if interest rate were to rise in the US market, the risk-return trade-off of investing in emerging markets becomes less favorable and therefore, the inflow could slowdown. Already countries like Australia and Britain have witnessed an increase in interest rates (in the case of Australia, two times) in order to steady economic growth.

Investors in the Indian stock markets have gained tremendously on the back of the rally witnessed in these markets. While internal factors like strong underlying fundamentals supported by valuations have acted as a strong positive, expectations on the FII inflow front have to be softened. Investing just because markets are 'expected' to touch new highs would not be prudent in any market. And more so in times like these, when temptations are aplenty, investors need to have a well-understood view of their risk-return profile and have a long-term investment horizon (3 to 5 years).

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