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.

Relationship between interest rates and equity markets

High-interest rates hurt company profits

➢ According to the RBI's monthly bulletin for January 2013, enterprises across sectors
paid 3.7 per cent of their sales as interest in the first half of the fiscal year 2012-13.
➢ This figure was only 1.6 per cent four years ago. This reduced the company's
profitability.
➢ Companies' net profit as a proportion of sales was 6.4 per cent in the first half of 2012-
13, down from 9.2 per cent four years before.

Small companies hit the most

➢ According to the RBI research of small, medium, and big listed companies, rising
lending rates have the greatest impact on small and medium-sized businesses.
➢ Banks force small businesses to pay higher loan rates than large businesses.
➢ Interest paid as a proportion of sales was 9.2 per cent for small businesses, 5.8 per
cent for medium businesses, and 3.3 per cent for big businesses.
➢ The RBI classifies small businesses as those with annual sales of less than Rs 100
crore.
➢ Medium-sized businesses have sales ranging from Rs 100 crore to Rs 1,000 crore.
➢ Large-sized businesses have sales of moreover Rs 1,000 crore.

High-interest rates reduce domestic participation in stock markets

➢ When interest rates are high, investors tend to retain their money in fixed deposits or
fixed return investments.
 ➢ In 2012, Indian investors withdrew funds from equities markets.
➢ According to the Securities and Exchange Board of India, mutual funds were net
sellers worth Rs 2,770 crore in January 2013.
➢ This indicates that Indian investors do not see the need to take any risks and play in
equities markets.
➢ Low-interest rates in the United States and other economies, on the other hand,
encouraged international institutional investors to riskier assets in developing
nations.
➢ So far in January 2013, FIIs have invested $ 3 billion in Indian equities markets.

High interest rates slow growth

➢ Companies' future development and expansion are also hampered by persistently

high financing rates.
➢ Companies are struggling to repay current debts and have put growth plans on hold.
➢ As a result, fewer occupations are available than previously.
➢ Companies also reduce their expenditure and consume less.
➢ This diminishes demand for products and services while also slowing economic
development.

Understanding how interest rates affect the economy

➢ Rising interest rates are generally unfavourable to a developing economy or the

stock market; yet, by slowing the economy, rising interest rates have the effect of
limiting inflation, which, if not managed, might be considerably worse.
➢ Interest rates that are falling serve to stimulate the economy.
➢ However, if the economy expands too quickly, it may cause inflation.
➢ Understanding how interest rate movements influence the economy can aid in
correctly placing finances and assets.
➢ Understanding how interest rates interact with other economic variables, on the other
hand, can be more predictive of future economic situations.
➢ People may delay spending if inflation is too low because they expect prices to
decline, harming the economy.
➢ When inflation is excessively high or erratic, it is difficult for consumers to plan their
spending and firms to establish pricing.
➢ Moderate inflation can assist consumers in making educated savings, borrowing,
and investment decisions.
Interest Rates and the Bond Market

➢ Interest rates have an influence on bond prices as well as the return on CDs,
Treasury bonds, and Treasury bills.
➢ Bond prices and interest rates have an inverse relationship: when interest rates
increase, bond prices fall (and vice versa).
➢ The longer the term of the bond, the more sensitive it is to changes in interest rates.

Impact of Expectations

➢ Nothing has to happen to consumers or businesses for the stock market to react to
changes in interest rates.
➢ Rising or declining interest rates can also affect investor psychology.
➢ When the Federal Reserve announces a rate rise, both firms and consumers will cut
back on spending, causing earnings and stock values to fall, and the market to fall in
expectation.

The Bottom Line

➢ Although the link between interest rates and the stock market is tenuous, the two tend
to move in different directions.
➢ As a general rule, when the Federal Reserve lowers interest rates, the stock market
rises; when the Federal Reserve raises interest rates, the stock market falls.
➢ However, there is no certainty as to how the market will respond to any specific
interest rate shift.

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

➢ The RBI announced its first rate rise in four years following an unplanned
meeting of the Monetary Policy Committee.
➢ 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 concerns about rising inflation, the RBI is expected to raise interest
rates again shortly.

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
➢ Changes in US Fed rates do not occur overnight, therefore knowledge about any
substantial action to be taken by the Federal Reserve begins to circulate in the markets
months before the news is confirmed by the Federal Reserve.
➢ This provides adequate warning and time for the equities markets to prepare,
preventing any sudden fluctuations.
➢ A rise in interest rates in the United States harms both Indian markets and the
economy.
➢ The market tends to decline, and foreign investors withdraw, foreign exchange reserves
begin to dwindle, the economy faces growing inflation, the rupee decreases against the
dollar, and so on.
➢ While a reduction in US Fed interest rates is a favourable signal for Indian markets, it
will attract new foreign investors.