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Jittery reaction across the markets & Fed rate lift-off

Fed-rate-YellenMarkets across the world have been jittery over the past few weeks ahead of the December 15-16 US Federal Reserve meeting that’s likely to have a rate ‘lift-off’. But does a rate lift-off or upward revision in the interest rates in the US necessarily warrant a jolt based reaction that the financial markets have witnessed lately, stemming from the fears of a capital flight out of the emerging markets across the globe.

The answer to this move lies in understanding the fundamental objective of the Fed to contemplate a hike in their benchmark interest rates. In order to highlight the undercurrent of this objective, we will step aside for a moment, from the usual data analysis and reasoning emanating out of that, and use an analogy that will enable our readers to understand the current situation in the right perspective.

The interest rates in the US have been hovering at near zero percent post the financial meltdown in 2008, which is a stimulus provided by the government to the US economy to spur business activity within the economy and create demand for goods and services.

Let’s consider for a moment, for ease of explanation, that the stimulus provided by the US government is akin to medical treatment offered to patients when their health is not doing well. So when the health deteriorates (economic health becomes bad), the patient is admitted to a hospital for treatment – that is a stimulus to ensure that the health improves. Therefore, when such stimulus is doled out to an economy, markets would usually cheer not because of the low interest rate regime, but because of the hope that such stimulus would eventually help the economy to improve its health.

Now coming back to the patient example, post medical treatment if the patient is showing signs of recovery, the hospital may discharge him (read as: if the US economy is showing signs of recovery, the stimulus would be lifted off since the economic health is no longer bad). What does this move signify – a cause for worry or a reason to cheer? Our guess is by now you have got the sense of what we are trying to underline.

Yes, if the world’s largest economy has shown improvement in its health indicators, it indicates the ~$17 trillion economy is poised for a growth, leading to higher consumption, which will have a positive cascading effect on the global economy and a favorable demand – supply equation. The rate lift-off or gradually taking away the stimulus will be a testimony to the US economic recovery, which, in our opinion, is a reason to be cheered.

Our conviction emanates from the fact that the Fed rate hikes in the past were associated and preceded with healthy economic fundamentals such as lower unemployment, higher additions to non-farm payrolls, higher retail sales and higher manufacturers’ new orders. Our conviction is based on our study of past Fed rate movements since 1998 and its reaction to key economic fundamentals, impact on currencies and commodities and the stock market. During the course of our study, we have found a strong correlation between the leading economic indicators in the US (such as jobs data, auto sales, retail sales, manufacturing output, etc.) and the movement in Fed rates.

Our study reveals that whenever these economic indicators showed improvements, the Fed increased the rates and vice versa. Further, our analysis also revealed that the narrowing arbitrage opportunity due to Fed rate hikes has never triggered a capital flight from emerging markets, and in fact, investors remained invested in these economies.This is corroborated by the fact that between 2004 & 2007, when the Fed raised interest rates on 17 successive occasions, emerging countries such as India, Brazil & China saw robust FII inflows that grew at a CAGR of over 20%, 75% & 36%, respectively, despite the arbitrage opportunity narrowing down.

This strongly underlines our conviction that capital flight is dependent more on the economic fundamentals of the destination countries rather than an adverse change in arbitrage opportunities.

During the same period, taking India as an example for emerging economies, the Indian stock market appreciated at an annual rate of 45% (207% on an absolute basis), which was a reflection of buoyant economic fundamentals – GDP growth in the range of 7.5% – 9.8% and the unemployment rate below 4.5%. The economic fundamentals, today, are akin to the growth demonstrated by the Indian economy during the Fed rate hike era (September 2015 quarter GDP growth of 7.4% higher than the June 2015 quarter growth of 7%).

Therefore, we believe that the much anticipated fear of a possible capital flight due to Fed rate hike (because of which the markets have been discounting) is unlikely to happen, and the foreign inflow of funds – like in the past – would be positive.

Based on our correlation analysis and pattern study of the Fed rate vis-à-vis the US macroeconomic indicators as mentioned above, the signs from these indicators, in the present situation, seem encouraging, which lead us to believe that the US economy is firming up. The country added close to 211,000 jobs in November 2015, much higher than the median forecasts of 200,000, and unemployment levels stands close to 5%, which are near its seven year low.

These numbers are testimony to the fact that the US economy is resilient, driven by consumer spending and job creation. This also shows that the world’s largest economy, which contributes to more than 20% to the global GDP, is well poised for consumption driven growth, which will have a positive impact on the global economy.

Therefore, the much anticipated Fed Lift-off is a sign of a rebound in the US economy that would dole out the long term benefits to India and other emerging economies across the globe. This, we believe, is a reason for the world to cheer than to be jittery.

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