Interest rate hike cycle globally

➢ The Federal Reserve is expected to raise interest rates for the first time since
2018 as it deals with rising consumer costs, and many Wall Street analysts
believe it may not be the last rate hike in 2022.
➢ The Fed's twin goal of maintaining stable prices and ensuring maximum
employment has recently been put to the test.
➢ On the one hand, inflation in February reached a four-decade high of 7.9 per
cent, yet the general economic recovery from COVID-19 has been impressive.
➢ According to the Labour Department, the US economy added 678,000 jobs last
month, the most since July, and the unemployment rate fell to 3.8 per cent.
➢ However, the disruption to commodities markets caused by Russia's war in
Ukraine and new COVID lockdowns in China have led to a bleak forecast for
inflation.
➢ Fed Chair Jerome Powell will deliver a highly anticipated news conference to
clarify the Fed's view on future rate rises, as well as whether recent geopolitical
threats have altered its mind.
➢ Although growing consumer prices have caused difficulty for many Americans,
particularly those with fewer means.
➢ The Fed has been hesitant to boost interest rates because it does not want to
disrupt fast hiring or, worse, push the economy into a recession.
➢ It first described the post-vaccine inflationary pressure as "transitory", and
stated that its priority was to ensure maximum employment for Americans.
➢ Fed policymakers have already reversed their view and are now expected to join
central bank peers such as the Bank of England in raising interest rates in 2022.
➢ When the Fed confronted such high inflation 40 years ago, then-chair Paul
Volcker engineered a severe recession with massive rate rises, but this
eventually set the foundation for decades of stable growth and low inflation.
➢ It was then known as "The Great Moderation."

What does this mean for markets?

➢ Rising interest rates aren't necessarily the best friend of the markets.
➢ The whole point of raising interest rates is to reduce total expenditure to
stabilise prices and battle inflation.
➢ Getting mortgages, vehicle loans, and credit card loans gets more expensive.
➢ Borrowing and spending money become more costly.
➢ The rising cost of borrowing for the typical consumer can be harmful to stocks,
particularly to growth businesses that invest heavily in generating revenues.
➢ Bond yields are intended to increase while equities decrease in a rising
interest rate environment, but this hasn't always been the case.
How Changes in Interest Rates Affect Inflation

➢ When the Federal Reserve raises its benchmark federal funds rate in response to rising
inflation threats, it essentially increases the stock of risk-free reserves in the
financial system, restricting the money supply available for purchases of riskier
assets.
➢ When a central bank lowers its target interest rate, it essentially expands the money
supply available to buy risk assets.
➢ Rising interest rates discourage consumer and company expenditure by raising
borrowing costs, particularly on regularly funded large-ticket items such as houses and
capital equipment.
➢ It also harms asset values, offsetting the wealth effect and making banks more
cautious in lending choices.
➢ Finally, higher interest rates indicate that the central bank will continue to tighten
monetary policy, dampening inflation expectations.

Pointers that highlight the relationship between interest rates and equity
markets

High-interest rates hurt company profits

➢ In the first half of the financial year 2012-13, companies across sectors paid 3.7% of
their sales as interest, according to RBI's monthly bulletin for January 2013.
➢ This was just 1.6% four years ago. This ate into company profits.
➢ The net profit as a percentage of sales for companies stood at 6.4% in the first half
of 2012-13 against 9.2% four years ago.

Small companies hit the most

➢ The RBI study of small, medium and large listed companies suggests that small and
medium-sized companies are hit hardest due to high-interest rates.
➢ Banks make small companies pay higher interest rates than large companies.
➢ The interest paid as a percentage of sales was 9.2% for small companies, 5.8% for
medium companies and 3.3% for large companies.
➢ RBI defines small companies as those with sales of less than Rs 100 crore.
➢ Medium-sized companies have sales between Rs 100 crore to Rs 1,000 crore.
➢ Large-sized companies are those with sales of over Rs 1,000 crore.

High-interest rates reduce domestic participation in stock markets

➢ Investors tend to keep their money in fixed deposits or fixed return assets when interest
rates are high.
 ➢ Indian investors pulled out money from equity markets in 2012.
➢ In January 2013, mutual funds were net sellers to the tune of Rs 2,770 crore, according
to the Securities and Exchange Board of India.
➢ This means investors in India do not feel the need to take any risk and bet on equity
markets.
➢ In contrast, low-interest rates in the US and other markets drove foreign institutional
investors to risky assets in emerging markets.
➢ In January 2013 so far, FIIs have injected $ 3bn into Indian equity markets.

High interest rates slow growth

➢ Future growth of companies and expansion is also affected due to persistent high-
interest rates.
➢ Companies struggle to repay existing loans and put on hold expansion plans.
➢ This results in fewer jobs than before.
➢ Companies also cut spending and consume less.
➢ This reduces the demand for goods and services and slows economic growth.

Understanding how interest rates affect the economy

➢ Generally, rising interest rates are not friendly to a growing economy or the stock
market.
➢ However, in slowing the economy, it does have the effect of curbing inflation, which,
if not controlled, could be much worse.
➢ Declining interest rates help stimulate the economy. However, if the economy grows
too fast, it can trigger inflation.
➢ Understanding how the direction of interest rates affects the economy can be helpful
in properly positioning the finances and investments.
➢ However, understanding how interest rates interact with other economic indicators can
be more predictive of future economic conditions.
➢ If inflation is too low, people may put off spending because they expect prices to fall,
consequently weakening the economy.
➢ If inflation is too high or volatile, it’s hard for people to plan out their spending
and for businesses to set prices.
➢ Moderate inflation can help people make informed decisions about saving,
borrowing, and investing.

Interest Rates and the Bond Market

➢ Interest rates also impact bond prices and the return on certificate of deposits (CDs),
Treasury bonds, and Treasury bills.
 ➢ There is an inverse relationship between bond prices and interest rates: as interest
rates rise, bond prices fall (and vice versa).
➢ The longer the maturity of the bond, the more it fluctuates to changes in the
interest rate.

Impact of Expectations

➢ Nothing has to happen to consumers or companies for the stock market to react to
interest-rate changes.
➢ Rising or falling interest rates can also impact the investor’s psychology.
➢ When the Federal Reserve announces a hike, both businesses and consumers will cut
back on spending.
➢ This will cause earnings to fall and stock prices to drop, and the market may tumble
in anticipation.

The Bottom Line

➢ Although the relationship between interest rates and the stock market is fairly indirect,
the two tend to move in opposite directions.
➢ As a general rule of thumb, when the Federal Reserve cuts interest rates, it causes the
stock market to go up; when the Federal Reserve raises interest rates, it causes the
stock market to go down.
➢ But there is no guarantee as to how the market will react to any given interest rate
change.

Hiking Cycle

➢ If 2020 was the year when global central banks extended generosity to safeguard the
world economy from the Covid crisis, 2022 is the year when monetary authorities begin
to tighten the easy money liquidity despite a bleak worldwide economic outlook.
➢ A combination of variables, including intermittent resurgences of the virus in various
areas of the world – China being the most recent example – and Russia's invasion of
Ukraine, worsened global supply disruptions, stoking inflationary tendencies
everywhere.
➢ Faced with the feared spectre of stagflation - slowed GDP and rising inflation –
monetary authorities throughout the world have begun an aggressive tightening cycle.

Following are some of the global central bank moves:

1) Reserve Bank of Australia

➢ For the first time in 12 years, the RBA raised its benchmark interest rate.
 ➢ The policy rate was raised to 0.35 per cent from 0.1 per cent, a higher rise than
the 25-basis-point increase anticipated by markets.
➢ The central bank also raised its inflation outlook, implying further rate hikes.

2) Reserve Bank of India

➢ Following an unscheduled meeting of the Monetary Policy Committee, the RBI

announced its first rate hike in four years.
➢ The RBI hiked the repo rate by 40 basis points to 4.40 per cent.
➢ It also hiked the Cash Reserve Ratio that banks have to maintain by 50 basis
points to 4.5 per cent.
➢ Given its warnings of elevated inflation going ahead, the RBI is likely to hike
rates again in the near term.

3) US Federal Reserve

➢ The Federal Open Market Committee (FOMC) established a new target range
for the federal funds rate of 0.75-1 per cent.

➢ The Fed also stated that it intends to shrink its balance sheet by $47.5 billion
per month through September.

➢ Markets jumped immediately following the news, as expectations of a 50 basis

point increase were high.

➢ However, with the Fed expected to boost rates multiple times this year, US stock
markets fell.

4) Banco Central Do Brasil

➢ For the tenth time in a row, the Brazilian central bank raised key interest rates,
raising the lending rate by 100 basis points to 12.75 per cent.
➢ Since 2021, the Brazilian central bank has tightened monetary policy by about
10% but has been unable to bring rising inflation under control.
➢ With economic growth risks increasing, the central bank is expected to
moderate the pace of rate rises in the coming months.

5) Norges Bank

➢ The Norwegian central bank expectedly kept benchmark policy rates

unchanged but repeated its intent to raise interest rates next month.
 6) Central Bank of Chile

➢ Chile's central bank raised interest rates by 125 basis points to 8.25 per cent,
above market estimates of a 100-basis point increase.

➢ Since January, the central bank has raised interest rates by 150 basis points.

7) Bank of England

➢ The week finished with the Bank of England raising benchmark policy rates for
the fourth time in a row to a 13-year high of 1%.

➢ While the rate action was expected, the Bank of England surprised investors by
projecting that inflation might reach 10%, the greatest pace of price growth
in 40 years.

➢ The central bank also foresaw a downturn.

How FED rates affect other economies?

➢ Despite the negative impact of US interest rates on the global economy, higher interest
rates promote international commerce.
➢ The stronger currency that will follow the rate hike should raise US demand for
items all over the world, enhancing business earnings for both local and international
firms.
➢ Because stock market variations reflect assumptions about whether sectors will expand
or decrease, earnings surges will drive the stock market to rally.

Some noteworthy points:

1. Higher US interest rates have huge overseas spillovers that are nearly as large as the
US impacts.
o After three years, a 100 basis point increase in US interest rates caused by
monetary policy affects
o GDP in advanced and emerging economies by 0.5 and 0.8%, respectively.
o These magnitudes are comparable to the domestic consequences of a US
monetary shock, which reduces US GDP by around 0.7% after two years.

2. Higher US interest rates are conveyed to advanced economies via standard exchange
rates and trade networks.
o When a country's currency is tied to the dollar or its trade volume with the US
is substantial, the responses inside advanced economies are very strong.
 3. In developing countries, exchange rate and trade channels explain only a small portion
of the variation in GDP responses between economies.
o Instead, a vulnerability index that we interpret as reflecting a country's
financial fragility explains a large component of economic inequalities, with
GDP in more sensitive nations falling far more in reaction to monetary
tightening in the United States.
o Current accounts, foreign reserves, inflation, and external debt are
combined to create this vulnerability index.

Interest rate trend of US vs India

Conclusion
➢ The changes in US Fed rates don't take place overnight.
➢ So, the news regarding any significant step to be taken by the Federal Reserve starts
roaming around the markets months before the news gets a nod from the Federal
Reserve.
➢ This serves the equity markets with ample warning and time to prepare, eliminating
any wild moves.
➢ A hike in the interest rates in the US impacts both the Indian markets and the
economy negatively.
➢ The market tends to come down, and the foreign investors pull out, foreign exchange
reserves start to deplete, the economy is at risk of mounting inflation, the rupee falls
against the dollar, etc.
➢ While a rate cut in the US Fed interest rates is a positive cue for the Indian markets as
it would drive fresh foreign investors to the markets.