US Fed meet, rising US dollar and its implications on emerging markets like India

The US Fed has kept the rates unchanged and continued with its monthly $120 billion bond-buying program without explicitly mentioning any timeline about tapering its aggressive bond-buying program unveiled during the depths of the economic downturn brought about by the Covid pandemic.

A section of the market believes that the Fed appears to be increasingly beholden to the economic and fiscal agenda of the US Administration that has proposed to spend $ 2.3 trillion on the Infrastructure development plan and $ 1.8 trillion on Family plan after being successful in passing a $ 1.9 trillion Coronavirus relief package to support businesses and consumers.

Central Bankers including the Fed fear that any disruptive rise in yields will jeopardize their respective government’s insatiable appetite to borrow at even lower rates.

However, with debt-to-GDP ratios soaring in many countries this benign neglect at best or dangerous indulgence at worst is bound to come back to haunt today's merrymaking fiscal and monetary profligates.

Fed also appears to be hostage to the markets and scared of triggering a sharp sell-off similar to the taper tantrum of 2013. This overly indulgent stance will fuel further risk-taking and set the stage for an eventual meltdown due to unsustainable valuations.

A large part of multi-trillion-dollar monetary and fiscal stimulus measures announced by various Central Banks and governments for reviving sputtering engines of the real economy has found its way into the financial economy and the tail (financial economy) has been allowed to wag the dog (real economy).

Stronger economic growth and earlier than expected increase in rates has led to the strengthening of the US dollar after the Fed meeting.

A sustained rise in the dollar can lead to the unwinding of carry trades with the reversal of foreign portfolio flows from emerging markets (EM) both in fixed income and equity back to developed markets (DM).

Such carry trades that typically use large leverage are underpinned by low-interest rates and weak currencies in countries of origin. Rising yields and strengthening currencies can act as triggers for such a reversal.

Besides, large amounts of short positions had built up in the US dollar over the last few weeks. Rapid covering up of these positions has the potential to add fuel to fire and further push up the US dollar.

Inflationary pressures are building up in many EMs including India and there is considerable pressure on the Reserve Bank of India (RBI) to keep yields low to aid the government's massive borrowing program. Any sharp fall in Rupee will worsen imported inflation adding to RBI's woes.

Hopefully, a near-normal, well-distributed monsoon as predicted by IMD; escape from the third wave of Covid enabling quick & complete opening up of the economy as well as a pick-up in vaccination rates should help in holding down price pressures.

The falling Rupee can provide a fillip to exports in an environment of fast-growing export markets in the developed world.

India can derive added benefit from softening global commodity prices which are typically quoted in dollars.

The relentless rise in valuations of financial assets in EMs including India due to torrent of foreign inflows remains highly vulnerable to rising yields and strengthening currencies in DMs particularly the US.

(The author is an Independent Market Analyst)

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