Tuesday's Talking Points
The third rate cut that was ‘hawkish’ – and how it changed perceptions!
What’s the Point?
The US FOMC, that sets rates for US central bank operations, decided to cut interest rates by 25bps last week (18 Dec), marking the third consecutive meeting ending with a decision to cut rates. However, the expectations set for the coming future through the ‘Dot Plot’, made the markets understand that rate cuts in 2025 will be slower than previously expected, from 4 cuts expected as of September to only 2. This led to a negative reaction in prices across equities, debt, and gold markets globally, while the dollar continued to strengthen against other currencies, including Rupee. FPI selling resumed in Indian equity markets in December (excluding primary markets), despite the month starting on a positive note. While the current environment suggests higher risks for India, overall external sector for India remains comfortable with large forex reserves, and a manageable CAD* position with cushion from Services exports. With increased yields, fixed income markets have provided another opportunity to accumulate duration in portfolios.
Numbers in Perspective
Source: US FRED, Bloomberg. *CAD: Current Account Deficit
Why was this rate cut considered hawkish?
The Fed expressed ongoing concerns about inflation in their post meeting discussion. They raised their inflation projections for 2024 and 2025, indicating that inflation is expected to be more persistent than previously thought. In fact, The Fed upgraded its GDP growth projections and noted that the labor market remains robust while lowering unemployment rate projections, reflecting a stronger-than-expected economy. This resilience reduces the need for aggressive rate cuts.
The Fed has a dual mandate to target maximum employment and price stability, and on both counts, rate cuts can now be lesser than previously thought. Hence, despite being in a rate cutting trajectory, this meeting turned out to be hawkish.
Negative market reaction across asset classes
- Fixed Income: Yields rose marginally across markets as the markets adjusted to a slower pace of rate cuts. In the US, the 2-year bond rose by 14bps to 4.36%, while the 10-year yield also rose by 5bps to 4.57%. In India, a similar reaction was seen, with the 10Y bond yields rising by 4bps to 6.78%.
- Equities: US Equities, now comprising >65% of the Developed Markets tracking MSCI World Index, fell approximately 3%, as represented by the S&P500 Index. Indian equities also had a negative reaction, with the Nifty 50 Index falling by 1.5% to 23,587.50 on Friday.
- Precious Metals and other commodities: Gold, which tends to have an inverse relationship with both dollar and real interest rates, seemed to have a negative reaction to the fed announcement. Oil futures showed a similar response.
Hawkish Fed strengthens the dollar even more!
Dollar strengthening trend continued post the Fed meeting outcome, with the Dollar Index that tracks performance of the USD against a basket of currencies, continued its rise that is being seen since mid-October. In fact, a jump of approximately 1.5% was seen around the Fed meeting announcement. As dollar continues strengthening, it reduces return expectations from other markets – increasing the risk of capital flight. India has been seeing negative FPI flows in equity markets for some time. In fact, while December started with positive FPI inflows, the position now has reversed, with December set to become the third consecutive month for FPI outflows with approximately Rs4,290 crores worth of outflows so far during the month excluding primary market activities.
Fixed income outlook – Time to Accumulate continues?
While the pace and extent of the Fed rate cuts have seen a change, the world continues to be in a monetary easing cycle. As highlighted in our recent note “Rethinking Fixed Income: Delayed not denied” dated 28 Nov 2024, the recent rise in yields can be used as an opportunity to increase duration in debt portfolios.
Conclusion
While the current environment suggests higher risks for India with some capital outflows, overall external sector for India remains comfortable with large forex reserves of US$652bn (as of December 13, 2024), and a manageable CAD position with cushion from Services exports. In fact, the reasons for this hawkishness have a silver lining, as a strong US economy is a good thing for India from an exports point of view. However, actions of the incoming US administration starting January 2025 are critical to watch out for, especially any tariff policy changes that could increase risks to inflation and further delay rate cuts. As highlighted earlier, higher yields in the fixed income markets present an opportunity to accumulate debt.
Sources: Bloomberg, I-Sec, Kotak Institutional Equities, CGA, RBI, and other publicly available information
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