The Big Story. The Fed can take a hike

The US Federal Reserve is almost certain to make its first move towards monetary policy normalisation this week. There have been enough hints from Janet Yellen and other Fed officials about this.

The Federal Reserve had tried to combat the effect of the sub-prime mortgage crisis by slashing rates aggressively from a high of 5.25 in June 2006 to 0-0.25 per cent by December 2008. Now, after a gap of seven years, the rates are set to move higher.

While financial markets are ready for the first 25 basis points rate hike in December, there is uncertainty over how far the rates will move up in the coming years, and how fast. A review of the changes in the Fed funds rate shows that both up and down cycles can last several years. In other words, we are just stepping into an upward cycle in Fed funds rate.

But is that a cause for worry? To answer that question, we looked at the past instances when the Fed embarked on a rate hike cycle, to gauge the impact on currency and stock market. Here’s the good news — stocks appear to thrive in phases when Fed fund rates move higher and the link between currency movement and interest rate changes appears rather weak.

The cause for worry stems from the increase in dollar loans taken by companies in emerging markets over the last seven years. There can be some turbulence if rate hikes take place too fast, making those who have taken such loans unwind. But that appears unlikely, given the flak that the Fed is already facing regarding its monetary policy decision.

If we look at the past four decades, there were two phases when the Fed tightened aggressively. The first phase was between November 1998 and May 2000, when the US central bank wanted to cool an overheated economy. It had hiked the Fed funds rate from 4.75 to 6.5 per cent in that period.

Another phase of sustained rate hike was between June 2003 and 2006. With cheap cost of funds causing a runaway increase in property prices and an increase in sub-prime mortgages, the Fed had used rate hikes to cool the property market.

But as we all know, this ploy failed to work and the rate increases only led to default on the sub-prime mortgages, leading to a crisis in the derivative market that traded instruments with these mortgages as the underlying.

In both these phases, the rate hikes failed to curb the exuberance in the stock markets. The period between 1998 and 2000 ushered in the dotcom rally in which internet stocks hit sky-high prices and traded at exorbitant valuations.

The S&P 500 continued to rally despite the rate hikes, moving from 1163 to 1420 in this period. It may be recalled that the Indian stock market was also caught up in the internet frenzy of that period and the Sensex too managed a 57 per cent gain then.

If we consider the period between June 2003 and June 2006, that was a bullish phase for almost all equity markets. Increasing risk appetite among global investors made them flock to emerging markets, including India.

The Sensex gained 194 per cent in that phase. The surge was spearheaded by the US market, where the gains were more modest. The S&P 500 moved 30 per cent higher in that period.

Contrary to stock prices, currencies do not appear to be too influenced by the Fed’s monetary policy moves. While it is widely believed that rising yields on US bonds attract investors into dollar-denominated securities, thus strengthening the dollar, this is not always true.

Between November 1998 and May 2000, the dollar index did gain 13 per cent along with rising rates.

But between June 2003 and 2006, the dollar index lost 8 per cent, even as the Fed aggressively hiked rates. There could be two reasons for this weak link. One, the relative strength of the dollar in relation to the euro appears to be the key determinant of the strength in the dollar index. Between 1998 and 2000, the euro lost ground against the dollar. But between 2003 and 2006, the euro gained. Two, the Fed is not likely to let the dollar appreciate too much as it would hurt exports and corporate profits.

Since the rupee’s fortunes are linked to the dollar, it is hard to establish a clear link between US rates and the rupee, too. The rupee depreciated from 42 against the dollar to 44.5 between 1998 and 2000. But it gained slightly in the next up-cycle between 2003 and 2006.

Growth in the US is critical to India since the US is among the largest export partners, with around 12 per cent share of the country’s exports. So, does the Fed rate hike peg back growth in the US? Not really.

The hikes do not immediately cause a fall in growth rates. In fact, in the two phases of rate up-cycle that we have analysed, the GDP growth of the US has remained steady. Indian exporters, at least, have no need to worry on account of the rate hikes.

The equation has become a trifle complicated this time due to the burgeoning dollar credit caused by the low cost of dollar loans. The Bank for International Settlements estimates that non-bank borrowers had outstanding dollar loans worth $9.8 trillion towards the end of June 2015: $3.3 trillion of these loans were taken by borrowers from emerging markets. Emerging market economy (EME) borrowers residing outside their countries have taken an additional $558 billion. In other words, the asset price inflation in many of the EMEs could have been funded by this dollar credit

India’s share of dollar credit taken by non-bank borrowers stood at $118 billion at the end of the June quarter of 2015. Of these borrowings, US dollar loans accounted for two-thirds of the borrowing. Bonds denominated in dollars accounted for the rest of the borrowings.

Increasing the rate of interest will hurt these borrowers when they try to renew their loans. Repayment amounts will also rise with dollar appreciation. But there has been much protest already from multilateral agencies as well as central bankers about the risk posed by these loans.

The Fed is, therefore, likely to take only measured steps without destabilising the global economy.