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Interest rate is cost of money. Lower the rate, easier it is to borrow. From the equity market perspective, money being one of the inputs for business, performance will be that much better. Not just for production, money finds its way into asset markets as well, e.g. equity market, for deployment. Hence the equity market is looking forward to it.
In the bond market, interest rate and price move inversely. When interest rate comes down, the bonds to be issued in future will carry a lower coupon (interest). Accordingly, the value of the existing (higher) coupon seems that much better, hence price goes up. Bond market is looking forward to it, as the price of existing bond holdings would go up.
To look at a bit of history on US Fed action, in 2020, during Covid times, they reduced the Fed rate to 00.25%, i.e. to near-zero level. In 2021, when inflation started inching up, they said inflation is ‘transient’. In 2022, when inflation was exorbitantly high, they raised the Fed rate fast and furious, bringing it to 5.25-5.50% by July 2023.
Since then, the market has been expecting them to reduce rates but their stance has been ‘higher for longer’, indicating interest rate would not be cut soon. Now, in the recent Jackson Hole speech, Fed chair Jerome Powell finally said, ‘the time has come’.
Why should they cut rates? Their gross domestic product (GDP) growth rate, which seems goody-goody, has been buoyed by high fiscal deficit and pumping of money by the government. Inflation, though somewhat higher than the target of 2% year-on-year, has eased. Consumer Price Inflation (CPI) is at 2.9% and Personal Consumption Expenditure (PCE) is at 2.5%. Their unemployment rate, latest reported data being at 4.3%, is inching up.
They are now worried about their labour market, GDP growth and the requirement of making cost of money more affordable. And another aspect, which the US Fed would not say in so many words, is their huge stockpile of debt. Outstanding US Treasuries is at approximately $35 trillion, which is around 125% of their GDP—highest since the second World War. Higher the interest rate, higher is the servicing burden.
The strength or weakness of the USD is measured against a basket of six global currencies with defined weightages. This measure, the U.S. Dollar Index, is referred to as DXY. It strengthens when interest rates are being hiked, and vice versa.
In the current situation, with heightened expectations of interest rate reversal, the DXY has been easing. For perspective, from 106.3 in April 2024, DXY has eased to 100.75 now. This is positive for our currency as there would be less pressure on the INR. However, it is positive for other Asian currencies as well. Hence, the relative movement of INR would be watched out by the Reserve Bank of India (RBI) for policy action.
From the perspective of our interest rate movement, the RBI follows its own judgement depending on our variables such as inflation. It has been stated by the RBI governor that ‘we do not follow the Fed’. Having said that, US being the bellwether market and the Fed being the ‘big brother’ among central banks, their rate action will influence central banks all over the world, including India.
The next meeting of the RBI Monetary Policy Committee (MPC) is scheduled for 9 October. Positive action and message from the US Fed will influence the MPC members’ decision. However, there is a nuance here. The term of the three external members is over. Three new external members will be nominated by the government by the review date. The views and opinions of the new members will have a bearing on the outcome.
Assuming the outcome of the US Fed review on 18 September is reduction of interest rate by 25 basis points (0.25%), while the impact on our equity and bond markets will be positive, it will be limited. The reason is, the market has already factored in this much. Market participants will look at the fine print, to decipher the future course of action and extent of future rate cuts.
Joydeep Sen is a corporate trainer (financial markets) and author