IMPACT OF FED RATE HIKE ON

INDIAN CAPITAL MARKET

INTRODUCTION
FEDERAL RATE
The fed funds rate is the interest rate banks in U.S. charge each other to lend Federal Reserve
funds overnight. These funds maintain the federal reserve requirement.

This Fed rate is what the nation's central bank requires they keep on hand each night. The
reserve requirement prevents them from lending out every single dollar they get.

FED rate makes sure they have enough cash on hand to start each business day.

The Federal Reserve uses the fed funds rate as a tool to control U.S. economic growth.

Banks use the fed funds rate to base all other short-term interest rates. It includes the London
Interbank Offering Rate, commonly called Libor. This is the rate banks charge each other
for one-month, three-month, six-month, and one-year loans.

Banks also base the prime rate on the fed funds rate. Banks charge their best customers the
prime rate. That's how the fed funds rate also affects most other interest rates. These include
interest rates on deposits, bank loans, credit cards and adjustable-rate mortgages.

How It Works

Longer-term interest rates are indirectly influenced. Investors want a higher rate for a longer-
term Treasury note. The yields on Treasury notes drive long-term conventional
mortgage interest rates.

The current fed funds rate is 2.0 percent. The Federal Open Market Committee raised it twice
in 2018, three times in 2017, once in 2016, and once in December 2015.

Before 2015, the rate had been zero percent since December 16, 2008. The FOMC had
lowered it to combat the financial crisis of 2008 . The Fed had aggressively lowered it 10
times in the prior 14 months. The highest was 20 percent in 1979. That's when Fed Chair Paul
Volcker used it as a tool to combat inflation. The fed funds rate highs and lows are found in
the historical fed funds rate

Banks hold the reserve requirement either at the local Fed branch office or in
their vaults. If a bank is short of cash at the end of the day, it borrows from a
bank with extra money. The fed funds rate is what banks charge each other
for overnight loans to meet these reserve balances. The amount loaned and
borrowed is known as the federal funds.

The Federal Open Market Committee sets a target for the fed funds rate. It
can't force the banks to use its targeted rate. Instead, it uses open market
operations to push the fed funds rate to its target.

If the FOMC wants the rate lower, the Fed purchases securities from its
member banks. It deposits credit onto the banks' balance sheets, giving them
more reserves than they need. That means the banks need to lower the fed
funds rate to lend out the extra funds to each other. That's how the Fed lowers
interest rates.

When the Fed wants rates higher, it does the opposite. It sells its securities to
banks and consequently removes funds from their balance sheet. This gives
banks fewer reserves which allow them to raise rates. Since 2015, the Fed
has been raising interest rates. That's one way it is controlling inflation.

The investment community and the financial media tend to obsess over interest
rates—the cost someone pays for the use of someone else's money— and with good
reason. When the Federal Open Market Committee (FOMC) sets the target for
the federal funds rate at which banks borrow from and lend to each other, it has a
ripple effect across the entire U.S. economy, not to mention the U.S. stock market.
And, while it usually takes at least 12 months for any increase or decrease in interest
rates to be felt in a widespread economic way, the market's response to a change (or
news of a potential change) is often more immediate.

Understanding the relationship between interest rates and the stock markets can
help investors understand how changes might affect their investments and how to
make better financial decisions.

The Interest Rate That Impacts Stocks

The interest rate that moves markets is the federal funds rate. Also known as
the overnight rate, this is the rate depository institutions are charged for borrowing
money from Federal Reserve banks.

The federal funds rate is used by the Federal Reserve (the Fed) to attempt to
control inflation. Basically, by increasing the federal funds rate, the Fed attempts to
shrink the supply of money available for purchasing or doing things, by making
money more expensive to obtain. Conversely, when it decreases the federal funds
rate, the Fed is increasing the money supply and, by making it cheaper to borrow,
encouraging spending. Other countries' central banks do the same thing for the
same reason.
[See some of the resources online brokers offer to keep track of the latest
central bank policies here.]

Why is this number, what one bank pays another, so significant? Because the prime
interest rate—the interest rate commercial banks charge their most credit-worthy
customers—is largely based on the federal funds rate. It also forms the basis for
mortgage loan rates, credit card annual percentage rates (APRs) and a host of other
consumer and business loan rates.

What Happens When Interest Rates Rise?

When the Fed increases the federal funds rate, it does not directly affect the stock
market itself. The only truly direct effect is it becomes more expensive for banks to
borrow money from the Fed. But, as noted above, increases in the federal funds rate
have a ripple effect.

Because it costs them more to borrow money, financial institutions often increase the
rates they charge their customers to borrow money. Individuals are affected through
increases to credit card and mortgage interest rates, especially if these loans carry
a variable interest rate. This has the effect of decreasing the amount of money
consumers can spend. After all, people still have to pay the bills, and when those
bills become more expensive, households are left with less disposable income. This
means people will spend less discretionary money, which will affect businesses'
revenues and profits.

[Revenue and profit growth can impact a company's stock performance. Learn
how to use that knowledge as you invest through our Investing for
Beginners course on the Investopedia Academy.]

But businesses are affected in a more direct way as well because they also borrow
money from banks to run and expand their operations. When the banks make
borrowing more expensive, companies might not borrow as much and will pay higher
rates of interest on their loans. Less business spending can slow the growth of a
company; it might curtail expansion plans or new ventures, or even induce cutbacks.
There might be a decrease in earnings as well, which, for a public company, usually
means the stock price takes a hit.

Interest Rates and the Stock Market

So now we see how those ripples can rock the stock market. If a company is seen as
cutting back on its growth or is less profitable—either through higher debt expenses
or less revenue—the estimated amount of future cash flows will drop. All else being
equal, this will lower the price of the company's stock. (For related reading,
see: Taking Stock of Discounted Cash Flow.)

If enough companies experience declines in their stock prices, the whole market, or
the key indexes (e.g., Dow Jones Industrial Average, S&P 500) many people equate
with the market, will go down. With a lowered expectation in the growth and future
cash flows of the company, investors will not get as much growth from stock
price appreciation, making stock ownership less desirable. Furthermore, investing in
equities can be viewed as too risky compared to other investments.

However, some sectors do benefit from interest rate hikes. One sector that tends to
benefit most is the financial industry. Banks, brokerages, mortgage companies and
insurance companies' earnings often increase as interest rates move higher,
because they can charge more for lending.

Interest Rates and the Bond Market

Interest rates also affect bond prices and the return on CDs, T-bonds and T-bills.
There is an inverse relationship between bond prices and interest rates, meaning as
interest rates rise, bond prices fall, and vice versa. The longer the maturity of the
bond, the more it will fluctuate in relation to interest rates. (For related reading,
see: How Bond Market Pricing Works.)

When the Fed raises the federal funds rate, newly offered government securities,
such Treasury bills and bonds, are often viewed as the safest investments and will
usually experience a corresponding increase in interest rates. In other words,
the "risk-free" rate of return goes up, making these investments more desirable. As
the risk-free rate goes up, the total return required for investing in stocks also
increases. Therefore, if the required risk premium decreases while the potential
return remains the same or dips lower, investors might feel stocks have become too
risky and will put their money elsewhere.

One way governments and businesses raise money is through the sale of bonds. As
interest rates move up, the cost of borrowing becomes more expensive. This means
demand for lower-yield bonds will drop, causing their price to drop. As interest rates
fall, it becomes easier to borrow money, causing many companies to issue new
bonds to finance new ventures. This will cause the demand for higher-yielding bonds
to increase, forcing bond prices higher. Issuers of callable bonds may choose to
refinance by calling their existing bonds so they can lock in a lower interest rate.

For income-oriented investors, reducing the federal funds rate means a decreased
opportunity to make money from interest. Newly issued treasuries
and annuities won't pay as much. A decrease in interest rates will prompt investors
to move money from the bond market to the equity market, which then starts to rise
with the influx of new capital.

What Happens When Interest Rates Fall?

When the economy is slowing, the Federal Reserve cuts the federal funds rate to
stimulate financial activity. A decrease in interest rates by the Fed has the opposite
effect of a rate hike. Investors and economists alike view lower interest rates
as catalysts for growth—a benefit to personal and corporate borrowing, which in turn
leads to greater profits and a robust economy. Consumers will spend more, with the
lower interest rates making them feel they can finally afford to buy that new house or
send the kids to a private school. Businesses will enjoy the ability to finance
operations, acquisitions and expansions at a cheaper rate, thereby increasing their
future earnings potential, which, in turn, leads to higher stock prices.

Particular winners of lower federal funds rates are dividend-paying sectors such as
utilities and real estate investment trusts (REITs). Additionally, large companies with
stable cash flows and strong balance sheets benefit from cheaper debt financing.
(For related reading, see: Do Interest Rate Changes Affect Dividend Payers?)

Impact of Interest Rates on Stocks

Nothing has to actually happen to consumers or companies for the stock market to
react to interest-rate changes. Rising or falling interest rates also affect investors'
psychology, and the markets are nothing if not psychological. When the Fed
announces a hike, both businesses and consumers will cut back on spending,
which will cause earnings to fall and stock prices to drop, everyone thinks, and the
market tumbles in anticipation. On the other hand, when the Fed announces a cut,
the assumption is consumers and businesses will increase spending and investment,
causing stock prices to rise.

However, if expectations differ significantly from the Fed's actions, these

generalized, conventional reactions may not apply. For example, let's say the word
on the street is the Fed is going to cut interest rates by 50 basis points at its next
meeting, but the Fed announces a drop of only 25 basis points. The news may
actually cause stocks to decline because assumptions of a 50-basis-points cut had
already been priced into the market. (For related reading, see: 8 Pshychological
Traps Investors Should Avoid.)

The business cycle, and where the economy is in it, can also affect the market's
reaction. At the onset of a weakening economy, the modest boost provided by lower
rates is not enough to offset the loss of economic activity, and stocks continue to
decline. Conversely, towards the end of a boom cycle, when the Fed is moving in to
raise rates—a nod to improved corporate profits—certain sectors often continue to
do well, such as technology stocks, growth stocks and entertainment/recreational
company stocks.

The Federal Open Market Committee, a division of the Federal Reserve Board, meets
throughout the year to determine the course of monetary policy. One important aspect of
this policy is the desired level of the federal funds rate. The fed funds rate is the rate that
banks charge each other for overnight lending. However, this rate is also an important
trigger for rates throughout the economy.
The Federal Reserve Board, known simply as "The Fed," changes the fed funds rate in
an attempt to control inflation. Runaway inflation is bad for the economy, as it increases
prices dramatically. This impacts both companies, which have to raise prices to keep up
with their increased costs, and consumers, who may not be able to afford these raised
prices. Increasing interest rates help harness inflation by reducing the money supply.

The Exchange Rate Impact

Dollar is one of the most influential currencies from the entire pack. Post
the US Presidential elections and the anticipation of a rate hike, the dollar
gained against the basket of global currencies. The fed rate hike is likely
to lead to Rupee depreciation, due to the cascading effect on all
emerging markets. As seen post the rate hike on Dec 15 the dollar index
rose to 103, highest level in last 13 years. This indicates pressure on
emerging market currencies like Rupee and Peso. Even developed market
currencies would possibly bear the brunt as Euro touched 1.05 against the
Dollar, a 14 year low. On domestic front, the RBI intervention may act as a
limited buffer since the RBI now is more accommodative of domestic
parameters such as inflation and growth. If RBI further reduces domestic
interest rates, it will further add to the Rupee fall, as the subsequent
interest rate hikes by US Fed will reduce the gap between interest rate
differential of US and India.

The FII Outflow

The anticipation of the rate hike and a stronger dollar post the US
presidential elections led to FII outflows worth Rs 18,909 Cr from the
Indian markets till now. The debt markets have seen outflow of ~Rs
43,000 Cr so far this year. The rise in the US bond yields post the
presidential election also induced the highest FII outflow since 2008 from
the Indian bond market. We may see further outflow with prospects of
improving US economy going forward as investors will prefer to invest in
US market both in debt (better yield) and equity (better economic
growth). The rate hike will bring volatility in the bond markets as it will
drive down price of 10 year domestic bond.
The Stock Market Impact
Stock markets will also be impacted by the rate hike due to outflow of
Foreign Institutional Funds. However, due to fundamental strong hold,
India would be better off compared to other emerging markets. The
consequent rate hikes would most likely affect the earnings of companies
with foreign revenue or debt exposure. Earnings of Import oriented
companies will be under pressure with a weaker Rupee, where as export
oriented industries will benefit from favorable foreign exchange gains.

Historically, we’ve seen that the rate hike has had only a short term
impact on Indian Stock Market. Considering the strong growth in India, it
is unlikely that the long-term investment story of India will get impacted
due to rate hike. But, in the short run, the negative effects of FII outflows
in expectation of the Feds move will outweigh the positives of a stronger
macro-economic picture, improving fundamentals and any significant
influx of capital from DIIs.
The Fed on Wednesday, 14 th December approved the first 25 bps interest
rate hike of the year. In addition, the FOMC indicated a higher rate in its
look ahead than projected back in September. The committee now
expects three rate hikes in 2017, two or three in 2018 and three in 2019.
This came on the back of the US unemployment at 4.9%, a positive figure
in Fed’s view and Inflation presently at 1.1%, below the Fed’s 2% target
which has indicated improvement in the US economy. Consequently the
Fed increased the interest rates by 25bps to 0.50%-0.75%.

Though the rate high was largely anticipated and priced in by the
markets, the commentary by Fed’s Chairwoman Janet Yellen was the
one to bring anxiety in the market.
Fed has warned further rate hikes in 2017 at an accelerated pace with
possibility of 3 rates hikes vs. expected 2 hikes. However, this time
around we see a potential divergence of monetary policies with the US’s
peer G-20 countries implementing loose monetary policy and even
quantitative easing.

The Fed rate hike will definitely have ramifications over the global
markets especially the emerging markets. The most relevant impact will
be seen in the currency exchange rates, bond yields and the stock
markets.
The Fed rate hike will have ramifications for the global markets and especially the
emerging markets. Let us understand how India’s markets and economy are likely
to be impacted at this juncture.

The usual scenario after a Fed rate hike has been that of sharp fall in equity indices,
a weaker rupee and sustained foreign fund outflows.

However, this time the impact may not be as sharp considering India’s economic
strength in the emerging market space and lack of better investment destinations
besides India.

The portfolio investors may not fly away from India for a long time after the Fed
rate hike as not many would want to miss out on the enormous growth opportunity
ahead. However, we should consider the following short-term impacts on the
Indian economy and markets.

Weak rupee
The Fed rate hike is likely to lead to Rupee depreciation, due to the cascading
effect on all emerging markets. Not much of intervention is expected from the
Reserve Bank of India (RBI) as the focus of RBI now is more towards domestic
parameters such as inflation and growth.

If RBI further reduces domestic interest rates, it will further add to the Rupee fall,
as the subsequent interest rate hikes by US Fed will reduce the gap between
interest rate differential between US and India.

FII Outflow
The sustained rate hardening approach of Fed might result in some foreign fund
outflows from India in the short-term. Improved US bond yields may result in
some outflows or limit future portfolio investments to some degree by investors as
they might prefer to invest in US market both in debt (better yield) and equity
(better economic growth).

The rate hike will bring volatility in the bond markets as it will drive down the
price of the 10-year domestic bond.

Equity Market Downside

The stock markets in the short-term would also be impacted by the rate hike due to
the outflow of Foreign Funds. However, due to the fundamental stronghold, India
would be better off compared to other emerging markets.

The consequent rate hikes would most likely affect the earnings of companies with
foreign revenue or debt exposure. Earnings of Import oriented companies will be
under pressure with a weaker Rupee, whereas export-oriented industries will
benefit from favourable foreign exchange gains.

Long-term Impact Unlikely

Considering the strong growth in India, it is unlikely that the long-term investment
story of India will get impacted due to the rate hike.
But, in the short run, the negative effects of FII outflows in expectation of the Feds
move will outweigh the positives of a stronger macroeconomic picture, improving
fundamentals and any significant influx of capital from DIIs

The Federal Reserve’s policy meeting is scheduled today, in which the United
States’ central bank is expected to increase interest rates by 25 basis points.
Ahead of the meeting yesterday, anticipating higher rates, not only US stocks
market was tense but Indian markets were too.
The expectation of higher Fed rates gained momentum when the newly-
appointed Federal Reserve Chairman Jerome Powell last month indicated that
the Fed will go ahead with interest rate hikes despite the market turmoil. Fed
rates are similar to RBI’s repo rate, which are used to control inflation. The
only difference is that RBI’s repo rate currently is 6%, while US Fed rate is just
1.25%, which may be hiked to 1.5% today.

Connected market:
In the globalised world, markets are connected. An increase in Fed rates will
be negative in general for the US stock market and if it leads to another round
of sell-offs, it will also have ripple effects on the Indian market.
Rupee Vs Dollar:
If the Fed rates are hiked, the value of the dollar would go up, thus
weakening Indian rupee in comparison. This might hurt India’s forex reserves
and imports. However, the weaker rupee is good for India’s exports but low
global demand and stiff competition would not leave much room for Indian
exporters to capitalise the situation. DBS said that India’s financing
requirements will keep the rupee vulnerable to rising US rates this year.
Bond market pressure:
Due to the higher Fed rates, US’ 10-year bond yields are expected to go up,
which will also put pressure on India’s 10-year government bond yields.
RBI repo rate:
 With higher Fed rates weakening the Rupee, India’s imports bill is likely to go
up putting pressure on the RBI to either increase repo rates or at least refrain
from cutting rates in the upcoming monetary policy meetings.
 Stocks could be in for a 3 to 5 percent correction before dip buyers jump in to put a floor in the
market, strategists say.
 Stocks sold off on a jump in interest rates and a health-care deal between Amazon, J.P. Morgan
and Berkshire Hathaway that analysts say could threaten margins of traditional health-care
providers.
 A 5 percent correction would be the biggest since the 5.3 percent decline around Brexit in June
2016.
 To understand which sectors would benefit, we should understand as to why
US Fed would want to raise rates. While there could be several reasons and
reasons for those reasons, the single most pursuit seems to be manage
expectations of inflation. This inflation is caused due to demand exceeding
supply, in a simplistic sense. In such a scenario, in India, whichever sector
today has matching supply for the demand would benefit. This demand can be
internal and external as well. When prices go up, manufacturers also hurry to
create capacity a) to catch the demand and b) and/or to build capacity before
their machinery costs go up. Thus, if US Fed does indeed raise rates, sectors
that are sensitive to external demand and internal capital expenditure spend
should see revenues going up.

What is the US Fed rate hike?

US Fed is the central bank for the US, like RBI is for India. US Fed rate hike refers to
the raising (hike) of interest rates that the US Fed is willing to provide to the banks of
US for lending and borrowing activities. This in turn increases the interest
rates of everything else in the US - of government bonds, of bank savings
deposits by customers, of consumer loans etc. Similar to how when RBI raises or cuts
interest rates in India, it affects the interest rates of your loans and deposits (FDs).

How does it affect India?

It primarily affects India by decreasing the value of India’s currency

against the US dollar.

In order to understand this, you need to understand the link between currency and
interest rates. In general, emerging economies like India have higher inflation and
higher interest rates than developed countries like US and Europe. For example, the
interest rates in India right now are around 7–8%, inflation is 5-6% whereas both
interest rates and inflation in the US are close to 1-1.5% .

So a lot of financial institutions raise/borrow money in the US on low interest rates

in dollar terms and then invest that money in government bonds of emerging
countries such as India in local currency terms to earn higher interest. Even after
taking into account the depreciation of the local currency due to higher inflation, the
investors still earn more than what they could have earned had they just kept their
money in the US bonds.
This is also known as the currency carry trade. As much as 2 Trillion Dollars are
invested in emerging markets currency carry trade.

Keep in mind that this is a risky investment because the emerging country’s currency
and economy is not as stable as that of the US. The investment can quickly lose
money if inflation in India rises sharply (something that is known to happen) or the
Indian government takes some policy measures which weakens the Indian currency.

Think of it like converting all of your Indian money and putting it in a bank in Nepal
to earn their FD interest rate. Anything that affects Nepal, now affects your
investment.

Now you can imagine what happens when the US raises its domestic interest rates.
The difference between interest rates of emerging countries like India and the US
decreases, thus making India less attractive for the carry trade. As a result, some of
the money (the most risk-averse money amongst all carry traders) exits India and
flows back to the US. These investors are selling their Indian investments, converting
the rupees they get from the sale to US dollars and sending it back to the US i.e. the
demand for dollars has increased while the demand for INR has decreased in the
forex market. Result - dollar increases in value while INR depreciates.

Effects of weaker INR i.e. a higher value of US dollar (eg Rs 72 per USD)

 More expensive imports eg crude oil -> inflation

 Good for Indian exporters - but they need to be able to capitalise on it
India imports more goods than it exports by about $100 Bn annually (Source) - and
the biggest imports are crude and oil related imports which are essential inputs for
the entire economy. Increasing price of crude hence means a chance of increasing
inflation.

This would also affect RBI’s monetary policy decisions going ahead.

Effects on capital markets (stock markets and bond markets) of India

As discussed above, the impact on bond markets is the most evident - there will be
outflows from risk-averse foreign investors in Indian bond markets.

What about the stock markets?

The effect on the stock markets is not as direct but more of a cascading effect.

The biggest financial institutions (those that hold trillions of dollars in total) are
global asset allocators - they invest in everything (stocks, bonds, currencies etc) and
every country (India, US, China etc) in proportion to its attractiveness and risks. US
bonds are the safest investments on the planet so they form the basis of judging
everything else. Whenever the expected returns from US bonds change, everything
else gets re-calibrated according to that. Now because of the Fed rate hike, the
interest offered by US bonds has increased so everything else has become slightly less
attractive in comparison. This will trigger some re-allocation from other investments
to US bonds. This implies outflow of some money from Indian equities to US bonds
for these institutions to match their new target allocations.
However, the stock markets are primarily dependent on the GDP growth outlook for
the country and after a possible short-term decline due to these outflows generally
get back to behaving according to the growth expectations unless such hikes keep
happening. The more such hikes, the more such re-allocation trades will be triggered
and the more such outflows will happen. Each hike is like a speed breaker and if the
road ahead is just full of speed breakers then that will considerably slow down the
overall progress.

How do all these things affect India and Indian Stock Market?

The difference between interest rates in the US and India is big, and a small hike in
the US may not be attractive enough. However, a signal from the US Fed will
ultimately lead to subsequent rate hikes. A series of hikes in interest rates in the US
over a period of time will raise the borrowing cost for carry trade (borrow from the
US and invest in India), and thereby reduce their risk-adjusted return in
India.Obviously, people of the US will get money from the US at a higher cost as
compared to now. On the other hand, the Reserve Bank of India has embarked on
cutting interest rates and has cut repo rates twice by 25 bps each. A cut in India and a
hike in US further reduces their risk-adjusted return. Experts also say that this may
make US bonds more attractive.Whenever the US hikes its Fed rates, they make their
bonds cheaper in order to minimize the flow of money in the market and that money
is taken by the government by issuing bonds to the public at a cheaper rate. The US is
in any case considered a safe haven,and investors looking for stable returns will be
more attracted towards US bonds.And thus there will be an exit of most of Financial
Institutional Investors (FIIs from the US) from Indian Stock Market, in return
plunging the Indian Stock Market.

Every country has a central bank akin to our own the ‘Reserve Bank of India (RBI)’
to regulate the commercial banks and craft and implement the the country’s
monetary policy. The ‘US Federal Reserve’ is the central bank of the US.

Central banks world over usually discharge following functions:

1. Regulate functioning of commercial banks in various ways.

2. Monitor and control liquidity in the economy by mopping of excess liquidity
in the system (by borrowing, raising limits of compulsory reserves like CRR
and SLR) and creating liquidity where there is a shortage
(recent Quantitative Easing measures of the US is an example).
3. Determining the Interest Rates through the ‘Repo and Reverse Repo Rates’.
4. Monitoring and controlling ‘Inflation’ or ‘Price Rise’ through the different
monetary measures discussed above.
Although stagnant or on a slight decline for a decade perhaps, the US still is a great
nation. Even though her economy is not in great shape (the US today carries the
highest external debt in the world), in the absence of a credible alternative, its
currency remains the last resort in an increasingly turbulent global economy.

In an effort to revive her sagging economy, the successive US governments, aided by

the Federal Reserve, have been implementing following stimulus measures:

1. Enhancing liquidity in the system through the most controversial and

undesirable ‘Quantitative Easing’ or in plain words ‘Printing of Money’.
 2. In order to boost investment, maintaining negative or ridiculously
lowinterest rates.
Since fortunately or unfortunately the US continues to be the dominant global power,
her actions, including those of the Federal Reserve impact the world economies and
financial markets, including the Indian stock market as follows:

1. Excess Liquidity: Though meant for boosting domestic

investment, cash invariably flows out and floods world markets. This results
in a lot of money chasing a small number of stocks and other financial
instruments. As per the latest study published by ‘Value Research’ an
incredible 40% of the free floating shares of the Indian stock market is held
by Foreign Institutional Investors or FIIs. This in-turn drives up valuations
to absurdly high levels, making many goos stocks unaffordable to value
investors.
2. Maintaining low interest rates for long periods of time adversely impact the
interest incomes of majority of common population - ultimately affecting
internal savings and investments, which was the goal of the measure in the
first place! Additionally it aids the flow of money from the US to global
markets, especially emerging economies like India, in search of better
interest rates and other investment returns.
In this overall scenario, in the light of signals emerging from the the US economy
that it is strengthening and realising in hind sight that the stimulus measures are
hurting the economy the Federal Reserve is attempting a course correction by
restoring healthy interest rates gradually.

Having covered the basics and understanding the background let us now address
your question in the following paragraphs.

1. An increase in interest rates by the US Federal Reserve will have the impact
of reversing the outward flow of liquidity. The FIIs will find it little more
attractive to invest in their own home country. As a result they start selling
their holdings in the world markets, causing a fall in stock prices globally.
2. In addition, an increase in interest rates at home will make the Dollar
stronger and conversely the other countries currencies, including the Indian
Rupee, weaker. This will force the hands of FIIs to sell immediately, as
otherwise they will face a double loss:
o A loss on sale that is certain to arise by selling latter in a falling market.
o The currency exchange loss; when the Indian rupee depreciates, rupees 68
will fetch one dollar today will fetch less than a dollar after a week.
In the end, when the Fed increases rates, global markets will fall and liquidity in the
global markets will reduce drastically. There is no doubt abiout this.

Based on various economists and market analysts, a US fed rate hike normally affects
India, in terms of dollar outflows, stock markets etc.

US Federal Reserve raises interest rates to 1% in bid to hold off inflation

The US Federal Reserve has sought to head off rising inflation with a third interest
rate rise since the 2008 financial crash and the second in three months, taking the
base rate from 0.75% to 1%. It is expected that interest rates will continue to rise but
at a cautious pace. Janet Yellen stressed that the central bank expected the economy
to grow at a rate that would warrant gradual increases in interest rates. That will be
taken as a hint that there will be two more rises during the course of 2017.

Earlier, there were worries that such a hike could lead to large-scale foreign outflows
from India leading to a market crash. However, Indian stocks took the
announcement in stride. Markets opened higher today after the announcement.

 Rupee to be stable: The Indian currency has been inching closer to the
Rs 65-to-a-dollar levels the past few sessions. Going forward, though,
analysts expect it to be stable. This is mainly because foreign investors are
unlikely to exit from their investments in India as they had in 2013. In fact,
credit ratings agency, Moody’s, expects the Indian rupee to be the least
exposed to depreciation, according to media reports.
 Focus on Indian economy: In 2013, India was the worst affected after
the US Fed announced the rollback of its ‘Quantitative Easing’ policy.
Today, however, India is likely to be the least affected party amongst all
emerging markets. This is because of the inherent strengths in its economy
like higher growth rates, falling inflation, and government reform measures.
Moreover, India is positively affected by the fall in global oil prices. All these
factors could help corporate profit growth. This is why investors are likely to
focus on companies benefited by these factors like auto, infrastructure and
capital goods companies.
 Domestic investment: In the last one year, domestic investors have
returned to the Indian equity market in droves. With inflation falling,
consumers are saving more. These savings, in turn, are being directed
towards equities. As a result, even if a few foreign investors exit, domestic
investment will likely support the markets.
 US-based sectors to do well: The US interest rate hike reflects that the
US economy’s recovery is now well entrenched. This bodes well for Indian
companies in the US. Pharma and IT companies in India get most of their
revenues from the North American market. With a stable rupee, these
companies could benefit.
 RBI rate cut: The Reserve Bank of India has regularly worried about the
potentially negative effects of a US Fed hike. If it sparked a huge FII
outflow, it could have harmed the Indian economy. With this uncertainty
out of the way, and if inflation remains weaker than RBI’s forecast, then it
gives the central bank further headroom to cut interest rates. This could
potentially give a fillip to demand for auto and home loans, which should be
a positive for private sector banks and non-banking finance companies
(NBFCs).

The Fed Rate Hike will have a host of implications on the Indian Financial
Markets ranging from depreciation of the Rupee to consolidation in the
stock markets. After 2008 crisis, US Fed slashed the interest rates to 0.00-
0.25% to support the economy. Since then US Fed has kept interest rate
constant to increase liquidity in the US market.
The emerging markets were the major beneficiaries of low-interest rates
since investors invested in emerging markets because US market was
fragile. But now the US economy is showing signs of improvement with
unemployment at 4.9%, a positive figure in Fed’s view. Inflation is presently
at 1.1%, below the Fed’s 2% target.

A recent poll of economists predicted that the Fed will further hike rates by
75 basis points in 2016-17. It’s highly unlikely that the Fed would hike rates
in its mid-November meeting foreseeing volatility induced by the US
Presidential Elections. This improves the probability of a Rate hike in
December. The consensus poll indicates a 25 bps rate hike in December.
However, at a time when one sees the potential divergence of monetary
policy with the US’s peer G-20 countries implementing loose monetary
policy and even quantitative easing, the Fed may take into account the
immediate consequence of raising US interest rates and apply a more
dovish approach to rate hike.

The most relevant impact of rate hike has been seen on the currency front
due to the higher demand for investment in the US. Leading to capital
outflow from emerging markets since investors will prefer to invest in US
market both in debt (better yield) and equity (better economic growth). As
seen in December 2015, after the Fed raised rates by 25 bps, the Indian
Rupee depreciated Rs 2.53 to lows of 68.80 by March 2016 as foreign
investors in Indian markets moved funds to US markets. The depreciation
of Indian Rupee will lead to higher current account deficit and higher
inflation.
Date Fed Rate BPS Rupee per Date Rupee per Dollar
Change Dollar post Hike
June 22, 0.00%- 25 44.99 Nov 25, 52.25
2011 0.25% 2011
Dec 16, 0.25%- 25 66.14 Feb 28, 68.80
2015 0.50% 2015

If Fed hikes rates further in December 2016, it will likely depreciate the
Rupee, due to the cascading effect on all emerging markets. Further, the
RBI intervention may act as a limited buffer since the RBI now is more
accommodative of domestic parameters such as inflation and growth. If
RBI further reduces domestic interest rates, it will further add to the Rupee
fall. As the subsequent interest rate hikes by US Fed will reduce the gap
between interest rate differential of US and India.

Stock markets will also be impacted by the rate hike due to outflow of
Foreign Institutional Funds. However, due to fundamental strong hold,
India would be better off compared to other emerging markets. The
consequent rate hikes would most likely affect the earnings of companies
with foreign revenue or debt exposure. Earnings of Import oriented
companies will be under pressure with a weaker Rupee, where as export
oriented industries will benefit from favorable foreign exchange gains. The
rate hike will bring volatility in the bond markets as it will drive down price
of 10 year bond.

Historically, we’ve seen that the rate hike has had only a short term impact
on Indian Stock Market. Considering the strong growth in India, it is
unlikely that the long-term investment story of India will get impacted due
to rate hike. But, in the short run, the negative effects of FII outflows in
expectation of the Feds move will outweigh the positives of a stronger
macro-economic picture, improving fundamentals and any significant
influx of capital from DIIs.
Date Fed BPS Sensex 6 Month Return 12 Month
Rate Change Post Rate Return Post
Change Rate Change
June 22, 0.00%- 25 18,845 15,540 17,429
2011 0.25%
Dec 16, 0.25%- 25 26,117 26,667 27,458
2015 0.50%

The above table shows 6 months performance of Sensex post Fed Rate
change announcements.
The rate hike would have only a short term impact led by outflow of FII
funds and currency depreciation. But, strong fundamental dynamics of
India markets will lead to little or no impact on US Fed Rate Hike in the
long run.

 The Fed adjusts the interest rates that banks charge to borrow
from one another, which is eventually passed on to consumers.
 Some economists say what the Fed is doing now is a bit
unusual, because it's raising rates even though inflation is
quite low.

Banks give out money all the time - for a fee.

When we borrow and then pay back with interest, it's how banks
make money.
The cost of borrowing - interest rates - makes a big difference on
which credit card you choose or whether you get one at all.

If your bank wants to make it more expensive to borrow, it's not as

simple as just slapping on a new rate, as a grocer would with milk.
That's something controlled higher up, by the Federal Reserve,
America's central bank.

Why does the Fed care about interest rates?

In 1977, Congress gave the Federal Reserve two main tasks: Keep
the prices of things Americans buy stable and create labor-market
conditions that provide jobs for all the people who want them.

The Fed has developed a toolkit to achieve these goals of inflation

and maximum employment. But interest-rate changes make the
most headlines, perhaps because they have a swift effect on how
much we pay for credit cards and other short-term loans.

From Washington, the Fed adjusts interest rates to spur all sorts of
other changes in the economy. If it wants to encourage consumers
to borrow so spending can increase, which should help the
economy, it cuts rates and makes borrowing cheap. To do the
opposite and cool the economy, it raises rates so that an extra credit
card seems less and less desirable.
The Fed often adjusts rates in response to inflation - the increase in
prices that happens when people borrow so much that they have
more to spend than what's available to buy.
However, what the Fed is doing right now is a bit unusual.

''This is the first tightening cycle where they've been concerned

about inflation being too low," said Alan Levenson, the chief
economist at T. Rowe Price.

The Fed's preferred measure of inflation last touched its 2% target

in 2012. So the Fed can't exactly argue that it is raising rates to fight
inflation, although it expects prices to rise.

So how do rates go up or down?

Banks don't lend only to consumers; they lend to one another as
well.

That's because at the end of every day, they need to have a certain
amount of capital in their reserves. As we spend money, that
balance fluctuates, so a bank may need to borrow overnight to meet
the minimum capital requirement.

And just as they charge you for a loan, they charge one another. The
Fed tries to influence that charge - called the federal funds rate -
and it's what they're targeting when they raise or cut rates. When
the fed funds rate rises, banks also hike the rates they charge
consumers, so borrowing costs increase across the economy.

Floor and ceiling

After the Great Recession, the Fed bought an unprecedented
amount in Treasurys to inject cash into banks' accounts. There's
now over $2 trillion in excess reserves parked at the Fed (there was
less than $500 billion in 2008).

It figured that one way to pare down these Treasurys was to lend
some to money-market mutual funds and other dealers. It does this
in transactions known as reverse repurchase operations, which
basically involve selling the Treasurys and agreeing to buy them
back the next day.
The Fed sets a lower "floor" rate on these so-called repos.
Then it sets a higher rate that controls how much it pays banks to
hold their cash, known as interest on excess reserves, or IOER. This
acts as a ceiling, since banks won't want to lend to one another at a
rate lower than what the Fed is paying them (at least in theory).

In July, the last time the Fed raised rates, it set the repo rate at 1%
and the IOER rate at 1.25%. With the 25 basis-point increase
expected on Wednesday, the new "floor" repo rate would become
1.25% and the ceiling 1.50%.

The effective fed funds rate, which is what banks use to lend to one
another, would then float between 1.25% and 1.50%.
When the Fed raises rates, banks are less incentivized to lend, since
they are earning more to park their cash in reserves. That reduces
the supply of money and raises its price.
As expected, the Federal Reserve raised interest rates for the first time this
year on Wednesday, March 21, 2018. When the Federal Reserve increases
interest rates, it directly impacts short-term interest rates with potential
effects like higher car loan and credit card rates and a slower job market. A
Federal rate hike can also impact mortgage rates indirectly and has special
significance for homeowners and buyers.

The Federal Reserve raised rates a quarter point, and similar increases are
predictedin June, September, and December. Rates rose from 1.5 to 1.75
percent, their highest in a decade. “Rising rates appear to be inevitable,” Scott
Cummins at Cornerstone Home Lending, Inc., says. “The consensus is for three
to four more rate hikes by end of the year. This will directly impact the APY on
bank accounts and the rates on credit cards and car loans, but I don’t expect
much of an impact on mortgage rates.”
Cummins says that, if anything, a Federal rate increase will give more support
to a steadily rising interest market over time, but he doesn’t anticipate drastic
changes immediately. “For those buyers who have been on the sidelines, it is a
great time to buy and lock in at both a lower rate and lower purchase
price. And with a new sense of urgency, sellers can often find the market
rewarding.”

You can get more information on how a Federal Reserve rate increase could
affect your monthly bills by reading our analysis of the last rate hike in 2017.
Our loan officers also discuss the possible impact of the predicted Federal rate
hike for March 2018, which just occurred, here as it relates to economic
growth, housing prices, and mortgage rate increases.
Things That Traditionally Increase When the Fed Increases
Interest Rates
The recent rise in the Fed funds rate will likely cause a ripple effect on the borrowing
costs for consumers and businesses that want to access credit based on the U.S.
dollar. That has an impact across numerous credit categories, including the
following:

The Prime Rate

A hike in the Feds rate immediately fueled a jump in the prime rate, which represents
the credit rate that banks extend to their most credit-worthy customers. This rate is
the one on which other forms of consumer credit are based, as a higher prime rate
means that banks will increase fixed, and variable-rate borrowing costs when
assessing risk on less credit-worthy companies and consumers.

Credit Card Rates

Working off the prime rate, banks will determine how credit-worthy other individuals
are based on their risk profile. Rates will be affected for credit cards and other loans
as both require extensive risk-profiling of consumers seeking credit to make
purchases. Short-term borrowing will have higher rates than those considered long-
term.

Savings

Money market and credit-deposit (CD) rates increase due to the tick up of the prime
rate. In theory, that should boost savings among consumers and businesses as they
can generate a higher return on their savings. However, it is possible that anyone
with a debt burden would seek to pay off their financial obligations to offset higher
variable rates tied to credit cards, home loans, or other debt instruments.

U.S. National Debt

A hike in interest rates boosts the borrowing costs for the U.S. government and fuel
an increase in the national debt. A report from 2015 by the Congressional Budget
Office and Dean Baker, a director at the Center for Economic and Policy Research in
Washington, estimates that the U.S. government may end up paying $2.9 trillion
more over the next decade due to increases in the interest rate, than it would have if
the rates had stayed near zero.

Things That Are Largely Unaffected When the Fed Increases

Benchmark Interest Rates
Auto Loan Rates
Auto companies have benefited immensely from the Fed’s zero-interest-rate policy,
but rising benchmark rates will have an incremental impact. Surprisingly, auto loans
have not shifted much since the Federal Reserve's announcement because they are
long-term loans.

Mortgage Rates

A sign of a rate hike can send home borrowers rushing to close on a deal for a fixed
loan rate on a new home. However, mortgage rates traditionally fluctuate more in
tandem with the yield of domestic 10-year Treasury notes, which are largely affected
by inflation rates.

Things That Traditionally Decrease When the Fed Increases

Interest Rates
Business Profits

When interest rates rise, that’s typically good news for the profitability of the banking
sector, as noted by investment giant Goldman Sachs. But for the rest of the global
business sector, a rate hike carves into profitability. That’s because the cost of
capital required to expand goes higher. That could be terrible news for a market that
is currently in an earnings recession.

Home Sales

Higher interest rates and higher inflation typically cool demand in the housing sector.
On a 30-year loan at 4.0%, home buyers can currently anticipate at least 60% in
interest payments over the duration of their investment. Any uptick is surely a
deterrent to acquiring the long-term investment former President George Bush once
described as central to “The American Dream.”

Consumer Spending

A rise in borrowing costs traditionally weighs on consumer spending. Both higher

credit card rates and higher savings rates due to better bank rates provide fuel a
downturn in consumer impulse purchasing.

How the Fed Uses It to Control the Economy

The FOMC changes the fed funds rate to control inflation and maintain healthy
economic growth. The FOMC members watch economic indicators for signs of
inflation or recession. The key indicator for inflation is the core inflation rate.
The critical indicator for recession is the durable goods report.
It can take 12 to 18 months for a fed funds rate change to affect the entire
economy. To plan that far ahead, the Fed has become the nation’s expert in
forecasting the economy. The Federal Reserve employs 450 staff, about half
of whom are Ph.D. economists.

When the Fed raises rates, it's called contractionary monetary policy. A higher
fed funds rate means banks are less able to borrow money to keep their
reserves at the mandated level. That means they will lend less money out,
and the money they do lend will be at a higher rate. That's because they are
borrowing money at a higher fed funds rate to maintain their reserves. Since
loans are harder to get and more expensive, businesses will be less likely to
borrow. This will slow down the economy.

When this happens, adjustable-rate mortgages become more expensive.

Homebuyers can only afford smaller loans, which slows the housing industry.
Housing prices go down. Homeowners have less equity in their homes and
feel poorer. They spend less, thereby further slowing the economy.

When the Fed lowers the rate, the opposite occurs. Banks are more likely to
borrow from each other to meet their reserve requirements when rates are
low. Credit card rates drop, so consumers shop more. With cheaper bank
lending, businesses expand. That's called expansionary monetary policy

Borrowing costs are rising,

but savers should benefit
When the Fed raises interest rates, it is trying to increase borrowing costs for
businesses and consumers to help keep the economy from overheating. So far,
the impact has been very modest. Interest rates on car loans and mortgages
have risen only slightly. Credit card rates, however, have increased steadily
since 2009 and could continue to rise as the Fed raises rates. And although
savers have so far seen little change in the rates they are paid on money they
keep in the bank, there is hope that would change.

Job growth, a key consideration

for the Fed, is robust
The economy has added 192,000 jobs a month on average since the Fed began
raising rates at the end of 2015. The unemployment rate has fallen to 3.8
percent, matching its previous lowest level in 2000. And the Fed’s own labor-
market index has been on a steady upswing since the financial crisis ended.
 The economy keeps growing, but
concerns about inflation persist
The economy has expanded at a fairly steady pace since the financial crisis
ended, and the Fed expects that growth to continue. The Fed regards an
inflation rate of about 2 percent annually to be healthy. Previously, the Fed
was concerned that inflation was too low, but if it continues increase quickly,
that might prompt it to raise rates faster.

. Tamed inflation
Most broad-based measures of prices indicate inflation has continued to remain
under control in the U.S. in recent years. The central bank’s target for inflation is 2
percent, but inflation has yet to hit the bull’s-eye on a sustained basis, as measured
by personal consumption expenditures, or PCE.

If the Fed achieves its objectives in steering the economy, inflation should remain
under control.

A positive inflation scenario after a rate increase might include “lower prices of
imported consumer goods, due to a likely higher exchange value of the dollar if our
domestic rate increases are not matched by policy tightening in other major
economies,” says Daniil Manaenkov, U.S. forecasting specialist at the Research
Seminar in Quantitative Economics at the University of Michigan.

3. More lending
A credit bubble rightfully received some of the blame for the financial crisis in
2007. In the aftermath, lending came to a complete stop.

Lending has resumed. “Banks may have a greater incentive to loan out reserves at
higher interest rates, and the increased flow of additional credit would boost
economic growth,” says Sean Snaith, director of the Institute for Economic
Competitiveness at the University of Central Florida.

4. More interest income for retirees

As a rate boost brings better returns to savings vehicles, senior citizens should
enjoy better paydays by putting their money in CDs and savings accounts. “Higher
interest rates on CDs and other financial instruments will particularly help older
Americans trying to live on their retirement savings,” says Lynn Reaser, chief
economist at Point Loma Nazarene University in San Diego.
As the population ages in coming years, many more Americans will come to
appreciate even modest increases in interest income during retirement when they
buy certificates of deposit.

5. Stronger dollar to boost purchasing power

As the Fed continues to boost rates (and with the outlook for more rate hikes to
come), the U.S. dollar gets more support. Ultimately, that means more purchasing
power with the greenback compared with other currencies.

Predicting moves in the foreign exchange market is difficult, but Snaith and other
economists say the dollar could strengthen further as the Fed boosts rates.

Fed tightening “is likely to mean a somewhat higher dollar, so people traveling to
Europe will do well,” says Dean Baker, co-director of the Center for Economic and
Policy Research in Washington.

6. Stocks will trade on fundamentals

As the Federal Reserve embarks on what officials have called “normalization”
(that is, a backing away from record-low rates), stock prices may start to make
more sense and not reflect the central bank’s easy monetary policy quite so much.

“A normalization of rates would return the focus to market fundamentals and off of
focusing on the nuances of each Fed statement,” says David Nice, former senior
economist at DS Economics in Chicago.

After the Federal Reserve hiked rates by 25 basis points to 1.75% on

expected lines, the domestic markets back home started off on a positive note
with the Sensex rallying nearly 100 points this morning. Earlier, top market
voices had pointed out that a rate hike on expected lines could provide relief
to the volatile Sensex and Nifty, while any surprises could add to volatility in
the markets. The FOMC (Federal Open Market Committee) chaired by
Jerome Powell who took over from Janet Yellen has raised interest rates and
also forecast at least two more hikes for 2018, signaling growing confidence
that U.S. tax cuts and government spending which is slated to boost the
economy and inflation and lead to more aggressive future tightening. We take
a closer look at key implications of US Fed hike on Indian stock markets.
Nuetral to positive for Sensex, Nifty
In a recent interview with FE Online, Anshul Mishra, Equity Fund Manager of
Union Asset Management Company said that the stock market is slated to see
heightened volatility in 2018, due to the rising global risk free rate. Notably,
following yesterday’s rate hike, HSBC says that the 10-year US yields around
2.93% currently could see some consolidation, as the Fed retained its earlier
inflation forecast. As the rates recede from all-time high levels HDFC
Securities, sees this coming in as a neutral to positive for the Indian stock
markets.
Markets can digest two more hikes
The Fed Reserve’s forecast of two hikes in 2018 will come as a relief to
markets, says HDFC Securities. “ History has shown that unless the real
interest rates rise beyond 2.5% the markets can very well take these hikes
into stride. So we are not worried by the three hikes in 2019,” VK Sharma,
Head PCG and Capital Market Strategy at HDFC Securities said in a note.
Less pressure on RBI
According to market experts, a more hawkish stance from the US could have
added put additional pressure on India’s apex bank RBI to hike interest rates,
which so far has kept the key policy rates unchanged. However, HDFC
Securities says that the current hike will not burden RBI to hike rates.
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The Fed is in the middle of a series of changes at the top of the organisation that will create added
uncertainty over the path of policy in the coming years. Ms Yellen is due to step down as chair to be
replaced by Jay Powell, one of the current governors, in early 2018, and Wednesday marks her last
scheduled press conference as Fed chair. Randal Quarles has recently come on board as the Fed’s
vice-chairman for financial supervision, and President Trump is nominating Marvin Goodfriend to be
another one of the governors. However further seats need filling including the vice-chair, which has
been vacated by Stanley Fischer. Among the changes ahead are the retirement of Bill Dudley, the
powerful president of the New York Fed, midway through next year. One key question is whether
Fed forecasts have started building in any stimulus from the near $1.5tn tax-cutting package that
Republicans are attempting to rush through Congress before the end of the year. In addition, Fed
rate-setters have been divided over how to read the surprisingly tepid inflation numbers that have
continued to accompany robust jobs and output growth. Core inflation measured by an alternative
gauge, the consumer price index, disappointed Wall Street on Wednesday morning, suggesting the
conundrum surrounding sluggish readings has yet to be dispelled. In the central bank’s economic
outlook, the median Fed policymaker predicted growth this year of 2.5 per cent, compared with 2.4
per cent in the September forecasting round, followed by growth of 2.5 per cent in 2018, up from
2.1 per cent in the previous prediction. GDP growth was tipped to be 2.1 per cent in 2019, and
longer-run growth is still expected to be 1.8 per cent, well shy of the Trump administration’s 2.9 per
cent growth outlook. Fed officials now see unemployment dropping to 4.1 per cent this year,
compared with 4.3 per cent in the prior forecast, and then 3.9 per cent in 2018 and 2019, compared
with 4.1 per cent. The central bank’s favoured measure of core inflation was tipped to be 1.5 per
cent this year, 1.9 per cent next year and 2 per cent in 2019, unchanged from the previous median
forecast

 In the United States, the federal funds rate is the interest rate at which depository
institutions (banks and credit unions) lend reserve balances to other depository
institutions overnight, on an uncollateralized basis. Reserve balances are amounts held
at the Federal Reserve to maintain depository institutions' reserve requirements.
Institutions with surplus balances in their accounts lend those balances to institutions in
need of larger balances. The federal funds rate is an important benchmark in financial
markets.[1][2]
 The interest rate that the borrowing bank pays to the lending bank to borrow the funds is
negotiated between the two banks, and the weighted average of this rate across all such
transactions is the federal funds effective rate.
 The federal funds target rate is determined by a meeting of the members of the Federal
Open Market Committee which normally occurs eight times a year about seven weeks
apart. The committee may also hold additional meetings and implement target rate
changes outside of its normal schedule.
 The Federal Reserve uses open market operations to influence the supply of money in
the U.S. economy[3] to make the federal funds effective rate follow the federal funds target
rate
 For stocks, the first interest rate increase is likely mostly priced
into the stock market. What happens next is a bigger unknown.
Looking at money markets, Martin Hochstein of Allianz Global
Investors estimates that investors believe that the Fed will
eventually raise the interest rate to 1.2% by 2017. But according to
the Fed’s economic projections, rates are likely to reach 2.6% by
2017. Historically speaking, though, Hochstein found that analysts
underestimated the last three rate hike cycles. So that 1.4
percentage point difference is a “huge gap that could start some
troubles,” added Hochstein.
 If the Fed ends up raising rates higher and quicker than investors
expect that will likely be bad for the stock market. Goldman Sachs
says that valuations of the stock market tend to drop 10% in the
first year of tightening cycles. In the past, shares of energy,
industrials, and technology often outperform other areas of the
 economy during a rising rate cycle. But given dropping oil prices
and lower demand from emerging markets, things may play out
differently this time, at least for energy and industrials.
 Banks often get pointed at as potential buys when interest rates
rise. And shares of the biggest banks have been rising lately. That’s
because they can benefit from higher interest rates as long as they
don’t have to pass that higher interest off to borrowers. But TIAA -
CREF’s data shows that financials only outperformed the market
14% of the time, dropping an average of 4%. Utilities tend to
underperform when rates rise. The sector has returned -5.8% on
average, if you exclude 2004’s blip. But 2004 shows there can be
surprises. In that tighten cycle, utilities were up 28%.
 For bonds, when interest rates rise, prices fall. And this time could
be worse than usual. That’s because interest rates are so low, they
won’t compensate for price drops. Using today’s yield, Hochstein
ran simulations using past interest rate rises, finding that short
term Treasuries could fall as much as 1.3% while long-term ones
could drop 10.4%, if rate hikes proceed as the market thinks. The
current yield on the 10-year Treasury bond is 2.3%. Meaning it
could take you five years to earn back in interest what you lose in
price over a year. So while bonds are typically a safer place for your
investments, these days that likely not the case, especially
considering the growing worries about corporate credit quality.
 The benefit could be anyone who has money in a bank account.
According to data from the Federal Reserve, Americans households
and non-profits (the Fed combines the two categories) have just
over $8.3 trillion in bank savings accounts. So a 0.25% increase
could mean an extra $21 billion in interest, or about $163 per
American household, a year. But, again, it’s not clear that banks
will actually pass that extra interest along to savers.
 As for borrowing, there is already a large gap between interest rates
and what most people pay on their credit cards. Greg McBride of
Bankrate.com says it usually takes more than one interest rate hike
 to impact credit card rates. Variable rate home loans usually adjust
once a year. If the Fed raises rates two or three times before your
next loan adjustment, then “you could see a noticeable interest rate
increase” on your house payments, adds McBride.
 But most borrowing rates, like 30-year mortgages, are tied to
longer term interest rates, which typical rise when the economy is
expected to do better. So if the Fed ends up raising interest rates
without sending us into a recession, then borrowing costs for
houses and autos could go up too, and that will cost consumers. But
hopefully the extra cost will be a small price to pay for a better
economy.

 Classification:
 The capital market in India includes the following institutions
(i.e., supply of funds tor capital markets comes largely from
these); (i) Commercial Banks; (ii) Insurance Companies (LIC
and GIC); (iii) Specialised financial institutions like IFCI,
IDBI, ICICI, SIDCS, SFCS, UTI etc.; (iv) Provident Fund
Societies; (v) Merchant Banking Agencies; (vi) Credit
Guarantee Corporations. Individuals who invest directly on
their own in securities are also suppliers of fund to the capital
market.

 Thus, like all the markets the capital market is also composed
of those who demand funds (borrowers) and those who supply
funds (lenders). An ideal capital market at tempts to provide
adequate capital at reasonable rate of return for any business,
or industrial proposition which offers a prospective high yield
to make borrowing worthwhile.

 ADVERTISEMENTS:
 The Indian capital market is divided into gilt-edged market
and the industrial securities market. The gilt-edged market
refers to the market for government and semi-government
securities, backed by the RBI. The securities traded in this
market are stable in value and are much sought after by banks
and other institutions.

 The industrial securities market refers to the market for shares

and debentures of old and new companies. This market is
further divided into the new issues market and old capital
market meaning the stock exchange.

 The new issue market refers to the raising of new capital in the
form of shares and debentures, whereas the old capital market
deals with securities already issued by companies.

 The capital market is also divided in primary capital market

and secondary capital market. The primary market refers to
the new issue market, which relates to the issue of shares,
preference shares, and debentures of non-government public
limited companies and also to the realising of fresh capital by
government companies, and the issue of public sector bonds.

 The secondary market on the other hand is the market for old
and already issued securities. The secondary capital market is
composed of industrial security market or the stock exchange
in which industrial securities are bought and sold and the gilt-
edged market in which the government and semi-government
securities are traded.
 Growth of Indian Capital Market:
 Indian Capital Market before Independence:
 Indian capital market was hardly existent in the pre-
independence times. Agriculture was the mainstay of economy
but there was hardly any long term lending to agricultural
sector. Similarly the growth of industrial securities market was
very much hampered since there were very few companies and
the number of securities traded in the stock exchanges was
even smaller.

 Indian capital market was dominated by gilt-edged market for

government and semi-government securities. Individual
investors were very few in numbers and that too were limited
to the affluent classes in the urban and rural areas. Last but
not the least, there were no specialised intermediaries and
agencies to mobilise the savings of the public and channelise
them to investment.

 Indian Capital Market after Independence:

 Since independence, the Indian capital market has made
widespread growth in all the areas as reflected by increased
volume of savings and investments. In 1951, the number of
joint stock companies (which is a very important indicator of
the growth of capital market) was 28,500 both public limited
and private limited companies with a paid up capital of Rs. 775
crore, which in 1990 stood at 50,000 companies with a paid
up capital of Rs. 20,000 crore. The rate of growth of
investment has been phenomenal in recent years, in keeping
with the accelerated tempo of development of the Indian
economy under the impetus of the five year plans.
 Factors Influencing Capital Market:
 The firm trend in the market is basically affected by two
important factors: (i) operations of the institutional investors
in the market; and (ii) the excellent results flowing in from the
corporate sector.

 New Financial Intermediaries in Capital Market:

 ADVERTISEMENTS:

 Since 1988 financial sector in India has been undergoing a

process of structural transformation.

 Some important new financial intermediaries

introduced in Indian capital market are:
 Merchant Banking:
 Merchant bankers are financial intermediaries between
entrepreneurs and investors. Merchant banks may be
subsidiaries of commercial banks or may have been set up by
private financial service companies or may have been set up by
firms and individuals engaged in financial up by firms and
individuals engaged in financial advisory business. Merchant
banks in India manage and underwrite new issues, undertake
syndication of credit, advice corporate clients on fund raising
and other financial aspects.

 Since 1993, merchant banking has been statutorily brought

under the regulatory framework of the Securities Exchange
Board of India (SEBI) to ensure greater transparency in the
operation of merchant bankers and make them accountable.
The RBI supervises those merchant banks which were
subsidiaries, or are affiliates of commercial banks.
 Leasing and Hire-Purchase Companies:
 Leasing has proved a popular financing method for acquiring
plant and machinery specially or small and medium sized
enterprises. The growth of leasing companies has been due to
advantages of speed, informality and flexibility to suit
individual needs.

 The Narasimhan Committee has recognised the importance of

leasing and hire-purchase companies in financial
intermediation process and has recommended that: (i) a
minimum capital requirement should be stipulated; (ii)
prudential norms and guidelines in respect of conduct of
business should be laid down; and (iii) supervision should be
based on periodic returns by a unified supervisory authority.

 Mutual Funds:
 It refers to the pooling of savings by a number of investors-
small, medium and large. The corpus of fund thus collected
becomes sizeable which is managed by a team of investment
specialists backed by critical evaluation and supportive data.

 A mutual fund makes up for the lack of investor’s knowledge

and awareness. It attempts to optimise high return, high safety
and high liquidity trade off for maximum of investor’s benefit.
It thus aims at providing easy accessibility of media including
stock market in country to one and all, especially small
investors in rural and urban areas.

 Mutual funds are most important among the newer capital

market institutions. Several public sector banks and financial
institutions set up mutual funds on a tax exempt basis
 virtually on same footing as the Unit Trust of India (UTI) and
have been able to attract strong investor support and have
shown significant progress.

 Government has now decided to throw open the field to

private sector and joint sector mutual funds. At present
Securities and Exchange Board of India (SEBI) has authority
to lay down guidelines and to supervise and regulate working
of mutual funds.

 The guidelines issued by the SEBI in January 1991, are related

in advertisements and disclosure and reporting requirements
etc. The investors have to be informed about the status of their
investments in equity, debentures, government securities etc.

 The Narasimhan Committee has made the following

recommendations regarding mutual funds: (i) creation of an
appropriate regulatory framework to promote sound, orderly
and competitive growth of mutual fund business: (ii) creation
of proper legal framework to govern the establishments and
operation of mutual funds (the UTI is governed by a special
statute), and (iii) equality of treatment between various
mutual funds including the UTI in the area of tax concessions.

 Global Depository Receipts (GDR):

 Since 1992, the Government of India has allowed foreign
investment in the Indian securities through the issue of Global
Depository Receipts (GDRs) and Foreign Currency
Convertible Bonds (FCCBs). Initially the Euro-issue proceeds
 were to be utilised for approved end uses within a period of
one year from the date of issue.

 Since there was continued accumulation of foreign exchange

reserves with RBI and there were long gestation periods of
new investment the government required the issuing
companies to retain the Euro-issue proceeds abroad and
repatriate only as and when expenditure for the approved end
uses were incurred.

 Venture Capital Companies (VCC):

 The aim of venture capital companies is to give financial
support to new ideas and to introduction and adaptation of
new technologies. They are of a great importance to technocrat
entrepreneurs who have technical competence and expertise
but lack venture capital.

 Financial institutions generally insist on greater contribution

to the investment financing, in which technocrat
entrepreneurs can depend on venture capital companies.
Venture capital financing involves high risk.

 According to the Narasimhan Committee the guidelines for

setting up of venture capital companies are too restrictive and
unrealistic and have impeded their growth. The committee has
recommended a review and amendment of guidelines.

 Knowing the high risk involved in venture capital financing,

the committee has recommended a reduction in tax on capital
gains made by these companies and equality of tax treatment
between venture capital companies and mutual funds.
 Other New Financial Intermediaries:
 Besides the above given institutions, the government has
established a number of new financial intermediaries to serve
the increasing financial needs of commerce and industry is the
area of venture Capital, credit rating and leasing etc.

 (1) Technology Development and Information Company of

India (TDICI) Ltd., a technology venture finance company,
which sanctions project finance to new technology venture
since 1989.

 (ii) Risk Capital and Technology Finance Corporation

(RCTFC) Ltd., which provides risk capital to new
entrepreneurs and offers technology finance to technology-
oriented ventures since 1988.

 (iii) Infrastructure Leasing and Financial Services (IL&FS)

Ltd., set up in 1988 focuses on leasing of equipment for
infrastructure development.

 (iv) The credit rating agencies namely credit rating

information services of India (CRISIS) Ltd., setup in 1988;
Investment and Credit Rating Agency (ICRA) setup in 1991,
and Credit Analysis and Research (CARE) Ltd., setup in 1993
provide credit rating services to the corporate sector.

 Credit rating promotes investors interests by providing them

information on assessed comparative risk of investment in the
listed securities of different companies. It also helps
companies to raise funds more easily and at relatively cheaper
rate if their credit rating is high.
 (v) Stock Holding Corporation of India (SHCIL) Ltd., setup in
1988, with the objective of introducing a book entry system for
transfer of shares and other type of scrips thereby avoiding the
voluminous paper work involved and thus reducing delays in
transfers.
