NAME – ANKITA SINHA

ENROLLMENT NO.-17BSP0398
SEC - B

IMPACT OF FED RATE HIKE ON INDIAN CAPITAL

MARKET
TABLE OF CONTENTS
SERIAL NO. CONTENTS PAGE NO.
1 INTRODUCTION 1-6
2 SURVEY OF EXISTING LITERATURE 7
3 OBJECTIVES 8
4 METHODOLOGY 8
5 MAIN TEXT 9-18
6 ANALYSIS 18-24
7 CONCLUSION 25-26
8 BIBLIOGRAPHY 26

INTRODUCTION
FEDERAL 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 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.

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FED RATE FROM PAST YEARS TO CURRENT YEAR

The Fed Funds rate in current year of 2018 is 2.0 percent.

The FOMC or Federal Open Market Community raised the fed rate 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.
The fed funds rate highs and lows are found in the historical Fed funds rate.

HOW THE FED RATE IS USED 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.

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. Home
owners 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 is called the
expansionary monetary policy.

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WHY DOES THE FED CARE ABOUT INTEREST RATES?
 In 1977, Congress gave the Federal Reserve two main tasks: (i) Keep the prices of
things Americans buy stable and (ii). 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.

 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.

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 and there was less than $500 billion in 2008.
 It figured that one way to pare down these Treasury 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 Treasury 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 .

 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%.

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  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.

HOW FED RATE CONTROLS INFLATION

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.

That's the way it is controlling inflation.

WHAT HAPPENS WHEN FED RATE HIKES?

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.

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.

HOW FED RATE EFFECTS THE U.S. MARKET

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

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 Banks 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.
 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.
 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. 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.
 The federal funds rate is used by the Federal Reserve (THE FED) to
control inflation. Basically, by increasing the federal funds rate, the Fed attempts to
shrink the supply of money available for purchasing, 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.
 The Prime Rate - A hike in the Feds rate immediately fuelled 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.
 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.
 Business Profits - When interest rates rise, that’s typically good news for the
profitability of the banking sector. 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.

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  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.
 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 FED RATE IMPACTS 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.

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.

The 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.

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SURVEY OF EXISTING LITERATURE
Dr. L.K. Tripathy - has done the research on “An Impirical Study Of Impact Of Fed Rate
Hike On Performance Of BSE SENSEX”. In this research paper he tried to examine the
primary factors responsible for affecting the Bombay Stock Exchange in India. He in this
research paper attempted to investigate the relative influence of the factor affecting BSE
index.

Alan Levenson, the chief economist at T. Rowe Price. – has quoted in the research paper
on “Fed Rate Rise Impact On US Capital” - 'This is the first tightening cycle where they've
been concerned about inflation being too low.’

Douglason G. Omotor – has done research on “Relationship between Fed Rate hike,
Inflation and Stock Market Returns”. In this research, he tried to find out the relation of Fed
rate hike, Inflation and stock market. In this research paper he suggests that stock market
returns may provide an effective hedge against.

Prof. Lawrence H. Summers – has done the research on “Stock Market & Owner-Occupied
Housing”, where he explained a sharp decline in the value of stock market and increase in the
price of owner occupied housing in the last decades. Both of these were result of increase in
Fed rate, US tax system. The result in his research paper indicates that the tax effects are
large enough to account for almost the entire relative price shift that has been observed.

Geert Bekaert and Eric Engstrom – has done he research on “Inflation & the Stock
Market; Understanding the FED Model”; the FED model postulate that the dividend or
earning yield on stock equal to the yield on nominal treasury bonds, or at least dividend; the
two should be highly correlated. They show that the effect is consistent with modern asset
pricing theory incorporating uncertainty about the real growth prospects and also habit based
risk aversion.

K.R. Shanmugam & Dr. Biswaroop Mishra- has done research on “Fed Effect on Stock
Return in India”. Their research contributes to the FED and Stock return relation literature in
developing countries by revisiting the issue with reference to the emerging economy, India.
Most specifically it tests whether the Indian stock market provides an effective hedge against
FED hike using monthly data on real stock return. The result of their study indicates: (i)The
Indian Stock market reflect the future real activity of NSE Nifty, BSE Sensex. (ii)The
negative stock return relation results due to unexpected component of Inflation. (iii) This
negative relation vanishes when we control inflation real activity relation.

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OBJECTIVES
 To analyse the impact of FED rate hike on Indian capital market, Indian securities
market, Indian currency and economy
 To analyse the impact of FED hike on bonds, equities, debentures, shares, treasury
bills.
 To analyse the impact of FED hike on exchange rates of India.
 The purpose is to check the degree of association between the Fed rate and the Indian
stock market indices.

METHODOLOGY
The objective of this study is to find out the relationship between the Fed rate and the Indian
Capital Market because the rise in Fed rate has got a considerable impact on Stock market of
India.
To analyse the impact of U.S. Fed rate hike on Indian currency, Indian security market,
bonds, equities, treasury bills, securities.
To analyse how due to fed rate hike the effect on value of Indian INR is against the U.S. $.
To find out the relation, we select the six indices of Indian stock market – BSE Sensex, NSE
Nifty, BSE Bank ex, Bank Nifty, BSE Consumer durables, BSE FMCG. Sensex and Nifty are
the major stock indices of India. If Fed rate hike and inflation affects these stock indices then
whole stock market gets affected.
The data for Sensex and Nifty is taken on closing date of 31st December every year.
Data of stock indices is taken from BSE ( www.bseindia.com); NSE ( www.NSEindia.com)
and Money-control (www.moneycontrol.com).
The purpose is to check here the degree of association between the Fed rate and the stock
indices mentioned here.
To figure out the impact of Fed rate hike on BSE index , NSE index and other indices of the
Indian capital market.
The purpose is to ascertain the final figures of these stock market indices after the impact of
Fed rate hike and inflation in Indian capital market.
The purpose is to figure out the final value of Indian securities, bonds, equities; etc. in
relation to the fed rate hike.
To ascertain the final outcome on Indian currency (INR) , Indian securities market, Indian
economy due to the drastical effect of FED rate hike in U.S.

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MAIN TEXT
ABOUT – IMPACT OF FED RATE HIKE ON INDIAN
CAPITAL MARKET
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.

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).

WHAT DID US FEDERAL RESERVE DO AND WHY?

The US central bank raised it’s benchmark federal funds rate for the first time in more than 9
years on Wednesday. The rate had been next to zero since December 2008 and was increased
by a quarter point to a range of 0.25-0.50 percent. The Fed said the economy has rebounded
enough since Great Recession that the rate should be rising.

The rate sets the basis for short term lending in the financial sector. But, combined with
expectations for future rate moves, it also guides longer term interest rates which affect how
much people pay on loans to buy homes and cars, how much business pay to finance their
activities, how much do banks pay savers for the deposits. It has a big impact what foreign
companies and Govt. pay to borrow.

IMMEDIATE IMPACT

The stock markets around the world pushed solidly higher, and on Wall Street the S&P 500
was up to 0.7% after the rate announcement.

The US dollar which has been stronger all year, rose 0.1% to $0.9498 per euro.

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

9
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.

IMPACTS OF FED RATE HIKE ON INDIAN SECURITIES MARKET

& ECONOMY

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 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

10
the subsequent interest rate hikes by US Fed will reduce the gap between interest rate

differential between US and India.

Downfall in market - FII may withdraw their money from the market. It is assumed that
they will sell off in the remaining trading session.

Increase in demand of Dollar - Demand for dollar will rise and due to this rupee will de-
valuate. This means expenditure on imports will rise.

Inflation - Due to increase in import expenditure, inflation will rise. Inflation rate rise from
5.41% to 6%. If it crosses 6% then RBI will postpone lowering of interest rates.

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.

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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.

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Fall in value of rupee
As the hike will give better returns to investors in the market, demand for US dollar will rise.
This means a stronger dollar that will led to fall in value of rupee. An expensive dollar will
mean that India will have to shell out more for imports, which will erode its finances.
In 2014-15 , the Govt. spent $112.748 billion on import of crude oil . India imports 80% of its
requirement of crude oil or 189.43 million tonnes in 2017.

Sharp fall in Forex reserves

In order to arrest the fall in rupee, RBI Governor Raghuram Rajan has been selling foreign
exchange which led foreign exchange reserves to fall by a cumulative $3.16 billion since the
beginning of 2016 to $347.21 billion as of January 2016. The reserves could be diminished if
the rate hike further weakens the rupee, forcing the Governor to sell more dollars.

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.

Impact on start ups:

Because the rate hike makes developed markets more attractive for investment, the global
private equity firms & venture capital firms who were investing heavily in Indian start-ups
will likely be less interested in the Indian start-up ecosystem.

However, some economists say emerging markets like India have already factored in US
interest rate hikes in their economic plans. So, according to them, there won't be any
significant impact when the actual rate hike is announced.

Some even say that the fear of the hike has been more harmful than the actual hike will be.
Besides, the rise of interest of .25% won’t damage too much considering there aren’t coming
more hikes in near futures. More important is India is one of the fewest countries which is

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performing exceptionally well in the global market with the strong govt. at the centre &
expected growth to be around 7.5-8.3% in 2015-16

MAJOR IMPACT OF FED RATE HIKE ON INDIAN CURRENCY &

STOCK MARKET

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 favourable 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.

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.

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EQUITY MARKET IMPACT
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.

BOND MARKET IMPACT

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.

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.

The 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.

15
FED rate hike primarily affects India by decreasing the value of India’s
currency against the US dollar.
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.

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.

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 i.e. 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 Billion annually - 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.

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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.

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.

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.

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.

So, 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.

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.

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 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 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.

Now, from these perspectives it is clearly demonstrated 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.

ANALYSIS

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.

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US Dollar will appreciate
If the US Fed raises the US repo rate this December, it will have a significant impact on the
global financial market. Indian Rupee is already trading at Rs 66.5 per dollar on the
expectation that US Fed will raise the US repo rate.

The Indian Rupee will considerably depreciate if US Fed increases the interest rate, which
will increase the cost of imports.

However, one can argue that export will also increase as Rupee will depreciate. But one
should note that India is a net importer and therefore, the imports will become expensive for
India. Besides, all the other currencies will also depreciate against US Dollar. Thus, it will
not have significant benefit to exports from India.

RBI may halt rate cuts

The Indian rupee is already trading at Rs 66.5 per Dollar. It will depreciate further if US Fed
will raise the interest rate . Therefore, RBI has to intervene to rescue the Indian Rupee.

But now, it is reverse, RBI has cut the policy rates while US Fed is about to increase the
interest rate which will put pressure on Indian Rupee. Thus, RBI will be reluctant to cut the
policy rates further.

Impact on Indian Equity Market

If US Fed will hike interest rate, the foreign investors will invest in US market since rate hike
will be an indication that US economy is improving and stable. Besides, the Indian Rupee
will depreciate if US Fed raises the interest rates.

Therefore, the foreign investors will fear that Indian Rupee depreciation will wipe out their
profits. Thus, they will start book profits. But, Indian market may not react too much to US
Fed rate hike since the Indian economy has improved and the GDP is growing in around
7.5%.

Impact on a slowing US Economy

As we have already discussed that if US Fed raises the interest rate, US Dollar will
appreciate. Therefore, the imports for the US will become cheaper while exports from the US
will become expensive. Thus, US companies will face more competition to sustain the market

share.

The US interest rate hike will also impact the US Dollar denominated Oil price. The price of
the oil will fall further which will eventually make tougher for US Fed to meet the inflation
target.

Moreover, it will become further difficult for the US shale gas industry which is already
struggling to compete with the global low oil prices. Thus, US Fed interest rate hike will
adversely impact the US industry in subdued global demand and low oil prices.

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IMPACT OF FED RATE HIKE ON INR RUPEE PER DOLLAR IN
2015-16
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 an 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

Fed hikes rates further in December 2016, depreciates the Rupee, due to the cascading
effect on all emerging markets. As the subsequent interest rate hikes, US Fed reduced the
gap between interest rate differential of US and India.

Stock markets got impacted by the rate hike due to outflow of Foreign Institutional Funds.
However, due to fundamental strong hold, India was better off compared to other
emerging markets. The consequent rate hikes would affected the earnings of companies
with foreign revenue or debt exposure. Earnings of Import oriented companies was under
pressure with a weaker Rupee, where-as export-oriented industries was benefit from
favourable 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

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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.

IMPACT OF FED RATE HIKE ON SENSEX IN 2015-16

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.

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.

IMPACT OF FED RATE HIKE ON BSE SENSEX AND NSE NIFTY IN

2017-18

The benchmark BSE Sensex dropped 162.35 points to close at 34,184.04 on Wednesday.

Also, banking stocks led by Axis Bank, Yes Bank, ICICI Bank and HDFC Bank took a hit
after the finance ministry set a 15-day deadline for banks to take pre-emptive action on
operational and technical risks, following a $2 billion fraud at Punjab National Bank.

In addition, sustained capital outflows and the rupee continued to trade at 3-month low of
65.31 against the US dollar, down 44 paise during the day.

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Investors turned cautious ahead of a series of macroeconomic data, brokers said. Industrial
production (IIP) and December quarter GDP growth numbers were set for release later in the
day.

Market sentiment suffered a jolt after other Asian markets closed with widespread losses and
European markets dropped in early trade, tracking a slump in the US stocks overnight after
the US Fed chair revived worries about a sharp increase in interest rates.

BSE SENSEX:

The Sensex resumed lower at 34,156,63 and dropped further to a low 34,076.45 due to
heavy selling pressure in view of foreign capital outflows and lower global cues before
closing at 34,184.04, a loss of 162.354 points, or 0.47 percent.

After a choppy trading session, the BSE Sensex ended at 34,046.94 points, down 137.10
points or 0.40%

NSE NIFTY:

The broader Nifty dipped below the key 10,500-level to touch a low of 10,461.55 and finally
concluded 61.45 points, 0.58 percent down at 10,492.85.

National Stock Exchange’s, (NSE’s) broader Nifty index lost 34.50 points or 0.33%, to end
at 10,458.35 points. Clearly, the higher-than-expected December-quarter economic
growth of 7.2% was not enough.

IMPACT OF FED HIKE ON FMCG

Fresh spell of selling dragged down most of the sectoral indices, led by metal, banking and
FMCG, capital goods, power and infrastructure ended in the negative zone, falling up to 1.21
percent.

A monthly survey showed India's manufacturing sector growth eased slightly in February as
factory output and new business orders rose at a slower pace.

The Nikkei India Manufacturing Purchasing Managers Index (PMI) fell from 52.4 in January
to 52.1 in February, indicating a modest improvement in operating conditions.

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IMPACT OF FED HIKE ON GDP

India saw a GDP growth of 7.2% in September-December of 2017-18, the fastest in five
quarters, while fiscal deficit as of January end was at 113.7% of revised estimates.

GDP growth was driven by stellar expansion in investment, although growth in private
consumption demand moderated.

GDP data confirm a recovery, but the FY 18 gross value added (GVA) growth estimate of
6.4% is lower than RBI’s projection of 6.6% and renewed banking sector concerns are a risk
to the investment cycle.

However, India will grow 7.6 percent in calendar year 2018 and 7.5 percent in 2019, amid
signs of economic recovery from impact of demonetisation and GST.

Analysts said rising US 10-year bond yields and Fed rate hikes may impact the liquidity that
has kept Indian markets afloat.

So far this year, foreign institutional investors (FIIs) have bought $371.90 million worth of
Indian shares, while domestic institutional investors (DII) pumped in Rs18,211.74 crore.

3 MAIN IMPLICATIONS FOR SENSEX & NIFTY FOR FED RATE

HIKE

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.
Top market voices had pointed out that a rate hike on expected lines could provide relief to
the volatile Sensex and Nifty.
Nuetral to positive for Sensex, Nifty
The stock market is slated to see heightened volatility in 2018, due to the rising global risk
free rate. Notably, following 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.

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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. The real interest rates rise beyond 2.5% the markets can very well take these hikes
into stride.
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.

 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.
 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.
 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.
 The benefit could be anyone who has money in a bank account. Acco rding 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

24
 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.

CONCLUSION

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 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 .
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.

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 the 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 low interest
rates.

However, with implementation of these measures, Indian stocks took the announcement in
stride. Indian Markets after the announcement made a benefit:

 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, 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

25
 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).

BIBLIOGRAPHY
 www.financialexpress.com
 www.hindustantimes.com
 www.indiainfoline.com
 www.moneycontrol.com
 www.bse-india.com
 www.nse-india.com
 www.livemint.com
 www.ndtv.com
 www.economictimes.indiatimes.com

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