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As US Fed lets party to go on, Indian bulls will need patience (Column: Currency Corner)
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By Vatsal SrivastavaJanet Yellen gave a classic US Federal Reserve talk when she addressed a
press conference after a globally-awaited meeting of the policy
committee on Wednesday. "Just because we removed the word patient from
our statement doesn’t mean we will be impatient," the chairwoman said.
While
signaling confidence in the economic recovery, and inflation climbing
back up to 2 percent target in the long run, Yellen gave no clear signal
about the timing of the first rate hike since 2008. Looking at the
price action in US equities and 10-year yields, coupled with the steep
sell-off in the US Dollar, the best guess would be: A June hike is off
the table.
The Federal Open Market Committee (FOMC) has placed
itself in a position of vigilance and not of action, thus letting the
market rally continue, supporting a revised expectation for the monetary
policy normalisation to begin late this year or early 2016. The Fed
characterized GDP growth as having “moderated somewhat†and is no longer
expanding at a “solid paceâ€. It specifically pointed to weaker exports
growth.
The Fed removed the word "patience" from the policy
statement, consistent with its desire to transition from time-dependence
to data-dependence. Expectations for lift-off indicated by the “dots
chart†were significantly lowered to a level more consistent with Fed
Funds futures.
Further, the Fed stated that a rate hike remains
unlikely at the April FOMC meeting. It lowered its forecasts for real
GDP growth and inflation over the 2015-17 span, and slightly downwardly
adjusted its long-term range for the unemployment rate from 5.2-5.5
percent to 5.0-5.2 percent.
As of the impact on India, the
structural bull market is intact but requires patience. There has been a
huge outflow of funds out of the US into Europe in the first quarter of
2015. According to analytics major EPFR Global, there has been a record
$33.6 billion outflow from US equities and $35.6 billion inflow into
European equities.
There is a good chance of US equities
witnessing strong buying after trading with a slight downtrend over the
past month. If the US rally is sustained over the next few weeks, the
Indian equity market will touch an all time high. But over the next six
months, one expects a healthy consolidation and expect the Nifty to
trade between 8200-8600.
There has not been an earnings uptick
as many had believed and there is a good possibility of EPS (earnings
per share) downgrades for next year. However, each dip is a great buying
opportunity. The strategy should still be to remain overweight on rate
sensitive and operating leverage plays. Quality autos, banks, cement and
oil (as a reform play) are great areas to park money on corrections.
But
the Reserve Bank of India (RBI) Governor Raghuram Rajan must ease the
monetary policy faster than consensus. The annual retail inflation,
based on consumer price index (CPI) was 5.4 percent in February and the
consensus view is that it will consistently undershoot RBI’s 6-percent
target through 2015 and average 5 percent in 2-15-16 financial year,
according to Citibank.
While monsoon is a risk factor to these
forecasts, the softer inflation readings should continue on account of
lower commodity prices, moderate minimum support price (MSP) hikes and a
deceleration in rural wages. Growth figures are nowhere close to
flattering given the equity valuations the markets are commanding.
Industrial
production continued to expand at a moderate pace of 2.6 percent
year-on-year in January as compared to a revised growth of 3.2 percent
the previous month. On a sectoral basis, mining and consumer goods
output contracted by 2 percent and 1.9 percent respectively in January
while electricity and manufacturing output rose by a meager 2.5 percent
and 2.8 percent respectively.
The ongoing economic reforms and
de-bottlenecking of investments will, of course, add to the growth rate
in the coming quarters, but this must be accompanied by a large fall in
the cost of capital. Negative yields made up 16 percent of the JP Morgan
Global Government Bond Index, following massive bond buying programs by
the European Central Bank (ECB) and the Bank of Japan
Against
this backdrop, one sees no reason why Indian bond yields should not fall
to 4-5 percent in two years. Both crude benchmarks -- WTI and Brent --
are set to test their recent multi-year lows with no visible catalysts
for a sustained the V-shap recovery. This alone should be reason enough
for Rajan to go out and ease 50-75 basis points more than market
consensus without the fear of inflation climbing back up.
The
biggest measure of confidence yet in the Indian economy can be gauged by
the price action in the US dollar-Indian rupee exchange rate. While the
US Dollar Index has rallied from 82 to 98 since last March, the Indian
Rupee has held ground and outperformed emerging market currencies.
Further, Yellen did refer to the recent greenback strength as a negative
for the US economy, thus sending the US Dollar Index down 2 percent.
We
should expect the US dollar index to trend lower over the next few
months back to 90-95 levels. We know the RBI are buyers at around 60-62
to recoup their reserves but an appreciation would support the interest
rate-easing cycle, and if Rajan eases faster than market consensus. A
sharp fall in the rupee’s value against the US dollar should not be one
of his major concerns.
There is also a pessimistic camp, but that
should be good news for the bulls. Crowded trades and consensus
economic views are almost always wrong. Thus, what’s comforting is that
there are influential market participants and policymakers extremely
vary of the Fed’s tightening timeline. Speaking in Mumbai on Tuesday,
International Monetary Fund (IMF) Managing Director Christine Lagarde
said US rate increases could induce yet another round of the Fed-induced
"taper tantrum" in emerging markets. She expressed her concern over the
"spillover effects" of premature tightening and warned that events of
last summer were not "a one-off event".
The world’s biggest
hedge fund manager Ray Dalio of Bridgewater Associates compared the
financial conditions today to those in 1937 in a recent note to clients.
He reminded investors that eight years after the 1929 stock market
crisis and at the end of four years of money printing, premature
tightening by the Fed led to a one-third slump in the Dow Jones
Industrial Average in 1937 and the sell-off continued into the following
year.
“We don’t know - nor does the Fed know - exactly how much
tightening will knock over the apple cart…what we do hope the Fed
knows, which we don’t know, is how exactly it will fix things if it
knocks it over. We hope that they know that before they make a move that
could knock over the apple cart,†he and his colleague Mark Dinner said
in that note.
But are we asking the right questions? The market
is asking whether the US economy can handle a 25 basis points increase
in interest rates. That to one's mind is really an insignificant
question, because it clearly can. Historically speaking, we will most
likely see a 2-3 percent drop in equity prices post the hike decision
but that dip will be bought into.
The US economy has enough steam
despite slower-than-expected retail sales data and wage growth to
absorb a 25 basis point hike after almost six years of near zero
interest rates. The key question is whether the US economy can grow fast
enough to handle the federal funds rate at 1.25-1.5 percent by end 2016
assuming the rate hike cycle begins in September.
The biggest
risk to global markets is not the normalisation of US monetary policy
itself, but the possible event that the US Fed has to go back into
easing mode. In that case, financial markets will lose all faith in the
efficacy of unconventional monetary easing policies and central banks.
More
importantly, this crash won’t be an isolated event in the US. We have
the European and Japanese markets rallying on the same policies followed
by the US Fed and they will not be spared from capitulation. The whole
definition of the risk on/risk off move would change -- more
quantitative easing would not lead to equities rallying and bond yields
compressing. It would be the exact opposite.
The above
observation however, will be a fat tail-risk event and a rational
analyst would put assign an extremely low probability value on these
outcomes playing out. Yellen-led US Fed clearly realises that the risks
of premature tightening far outweigh the risks of prolonging its easy
money policies.
One can argue whether Yellen was hawkish or
dovish in her press conference. But referring to equity valuations being
"not outside of historical ranges", she certainly doesn’t want the
market to turn bearish. Not as yet.
(Vatsal Srivastava is consulting editor for currencies and commodities with IANS