Explained | How can a deeper Fed rate hike impact India?

Federal Reserve Chairman Jerome Powell (File image)

Price pressures are accelerating in the US, despite the Federal Reserve’s interest rate hikes and efforts to scale back pandemic-era liquidity surplus. The latest inflation print was a shocker. Inflation in the US rose to a 41-year high of 9.1 percent from a year ago in June -- higher than estimates and way above the Fed’s target of 2 percent.

Now, the odds are that the Fed could ramp up its battle to anchor inflation expectations and may go in for a 100 basis points (bps) rate hike this month, from the earlier expectations of a 75 bps hike. According to the CME FedWatch Tool, odds of a 100 bps rate hike at the July meeting have risen to almost 50 percent from 7.6 percent one day before the inflation data. The Fed policy meeting is scheduled for July 26-27.

An oversized Fed rate hike could send ripples across the global markets, further accentuating concerns of a recession in the US. Specifically for India, it could increase the pace of foreign outflows, add to the rupee’s woes and weaken domestic macros.

Here are five ways in which a deeper Fed rate hike could impact India.

Heightened risk aversion

If the Fed hikes rates aggressively, it could bolster expectations that the US economy is headed into a recession. The US bond yield curve inverted following the inflation data. This means that the yields of shorter-term government bonds yielded higher yields than longer-term ones. An inversion of the yield curve is a leading indicator of a recession.

If recessionary concerns deepen, it will see investors sticking to safer assets, like gold, and shunning riskier assets. Foreign investors have already pulled out more than $30 billion from Indian bond and equity markets so far in 2022. This could pick up pace if risk aversion sets in and foreign investors become further bearish on India.

“Higher interest rates in the US, coupled with a global risk-off sentiment, will make emerging assets less attractive for foreign investors,” said Aditi Gupta, economist at Bank of Baroda. “Foreign portfolio investors have remained net sellers in the Indian market since October, and aggressive rate hikes will only add to these woes.”

Narrowing interest rate differential

During COVID, interest rates in the US were near-zero levels, which is why emerging market asset classes, like India, were lucrative for foreign investors. Now, if the Fed’s rate increases are faster than that of the Reserve Bank of India (RBI)-led Monetary Policy Committee (MPC), it could narrow the interest rate differential between the two countries and accelerate outflow of dollars from India’s debt and equity markets.

Currently, economists expect the MPC to hike the repo rate by 35-50 bps in the August policy, lower than what is expected from the Fed.

“The primary driver for the MPC is likely to be domestic inflation and growth trends,” said Sakshi Gupta, an economist at HDFC Bank. “Domestic inflation is showing early signs that it might ease below 7 percent in July and could provide room for the MPC to not get as aggressive as the Fed.”

Weaker rupee

The consequence of the narrowing interest rate differential will be borne by the rupee. The rupee has been on a downward spiral against the dollar, of late, with the Indian currency hitting a record low, practically every day. The rupee tumbled to a fresh low of 79.96 to the dollar on July 15, according to Bloomberg data.

If the interest differential between India and the US shrinks, it will lead to a drop in forward points and the incentive to take on carry trades will be low. Not just that, a global dollar shortage, increase in foreign portfolio outflows and widening trade deficit will further put pressure on the Indian currency.

“FPI outflows can remain negative till the twin challenges of an aggressive Fed and recession risk next year are not resolved,” said Anindya Banerjee, vice president - currency derivatives & interest rate derivatives, at Kotak Securities. Banerjee expects the rupee to depreciate towards 80.50 to 81.00 against the dollar eventually.

According to Amit Pabari, managing director of CR Forex, outflows could only halt if the RBI keeps on liberalising policies for FPIs and smoothen ways to invest in India.

Also read: US inflation outpaces India’s. Then why the dollar gets stronger than the rupee

Widening trade deficit

A weakening rupee threatens to further widen India’s trade deficit - the difference between total exports and imports. A weaker rupee translates into costlier imports. Already, India’s merchandise trade deficit soared to a record $26.1 billion in June, from $20.4 billion in April and $23.3 billion in May. This could consequently widen the current account deficit further.

According to Upasna Bhardwaj, chief economist at Kotak Mahindra Bank, the current account deficit is likely to remain “reasonably elevated” at 3 percent of GDP for FY23.

Upward pressure on bond yields

Indian bond yields typically react to wild swings in the US bond market and global oil prices. If the Fed hikes rate more aggressively, it could push the 10-year US yield higher. Consequently, the Indian 10-year bond yield will also see an upward pressure, in the backdrop of heavy debt supply and a weakening rupee. This means that the government’s borrowing costs are set to rise.

“It is critical for the bond market to monitor rupee depreciation, Fed rate hikes and US treasury yield movements and oil prices. The 10-year Indian bond yield will react to all these factors,” said Venkatakrishnan Srinivasan, founder and managing partner at Rockfort Fincap, a Mumbai-based debt advisory firm.

“We now expect the market to trade in the 7.30-7.60 range till September and between 7.50 and 7.75 by December. It may go higher, subject to supply concerns and MPC hiking policy rates quickly, based on Fed rate hikes,” he added. The 10-year bond yield is currently trading at 7.41 percent.