This is How The US Fed Affects Your Stocks

They say that investing is a game of knowledge asymmetry. This holds true to large extent.

Investors can become as financially savvy as possible, but it is not financial literacy that will generate good returns in the long run.

Market awareness and information asymmetry, on the other hand, are what truly create the difference.

An investor needs to be aware of a variety of factors to stay updated on macroeconomic changes. One of these is the Federal Reserve's interest rate decisions.

The US Fed's benchmark interest rate is the cost that banks must pay to borrow cash from the US Federal Reserve.

You might be wondering how a foreign federal bank's interest rate decision influences stocks worldwide, especially in India.

Markets do not work in isolation; rather, they are interconnected.

Understanding the relationship between interest rates and the stock market can help investors anticipate how changes in interest rates will affect their assets.

They can also be better equipped to make sound financial decisions.

So, let's understand how it works.

The Impact of the Interest Rate Decisions

The US Reserve Bank is the central bank of America. Its like the RBI in India.

The Fed interest rate might be considered equivalent to the repo rate charged by the RBI to Indian banks for lending cash.

An increase in interest rate elevates short-term borrowing costs for financial institutions.

This has a ripple effect on virtually all other borrowing costs for companies and consumers in an economy.

While the decrease in the interest has the opposite effect. It is seen as a catalyst for growth and beneficial to personal and corporate borrowing.

How the Fed Rates Impact India

US being the strongest economy in the world, has the impact of its decisions seen throughout the world, including India.

In terms of the federal rate decisions, there can be two scenarios.

• An increase in Interest Rates

  When there is in increase in the Interest rate, it will narrow the gap in interest rates between India and the US.

  Therefore, foreign investors will be tempted to withdraw from Indian markets and invest in US.

  The increase in the federal rates increase the expectation of return from the US market, making it less lucrative to invest in the emerging markets like India.

  An increase in interest rates would also result in a weaker rupee in comparison to the dollar. This would again bring foreign investors lower returns on their investments.

• A Decrease in Interest Rates

  A rate cut by the Fed is a boost to the equity markets.

  Developing economies like India will always benefit from rate cuts because foreign investors will be lured toward the high returns the Indian economy promises.

  Lower interest rate rates mean cheaper borrowing for businesses which helps them to expand, leading to increased profitability.

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  Ultimately, foreign investors want a premium to remain invested in India. Without it, the risk of investing in an emerging market versus a developed one is not justified.

  For instance, as a western citizen, where would you prefer to park your savings, a 10-year government bond of the US versus one in India having almost the same yield?

  Most of you would likely choose the US, unless the Indian government compensates investors for the extra risk inherent in a developing economy.

Conclusion

The changes in US Fed rates don't take place overnight.

Hence, months before the Federal Reserve approves the news, rumours about any big action the Fed will take begin to circulate through the markets.

This serves the equity markets with ample warning and time to prepare, eliminating any wild moves.

However, all these instances are simply hiccups for a long-term investor.

We reiterate that you should stick to your asset allocation and stay the course.

Happy investing!

Warm regards,


Vinay Rawal
Research Analyst, Hidden Treasure
Equitymaster Agora Research Private Limited (Research Analyst)

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...