What is US Federal Reserve and How will a Fed Rate Hike Affect the Indian Stock Market?

Every country has a central bank akin to our own the ‘Reserve Bank of India (RBI)’ to regulate the commercial banks and craft and implement the the country’s monetary policy. The ‘US Federal Reserve’ is the central bank of the US.

Central banks world over usually discharge following functions:

1. Regulate functioning of commercial banks in various ways.
2. Monitor and control liquidity in the economy by mopping of excess liquidity in the system (by borrowing, raising limits of compulsory reserves like CRR and SLR) and creating liquidity where there is a shortage (recent Quantitative Easing measures of the US is an example).
3. Determining the Interest Rates through the ‘Repo and Reverse Repo Rates’.
4. Monitoring and controlling ‘Inflation’ or ‘Price Rise’ through the different monetary measures discussed above.

Although stagnant or on a slight decline for a decade perhaps, the US still is a great nation. Even though her economy is not in great shape (the US today carries the highest external debt in the world), in the absence of a credible alternative, its currency remains the last resort in an increasingly turbulent global economy.

In an effort to revive her sagging economy, the successive US governments, aided by the Federal Reserve, have been implementing following stimulus measures:

1. Enhancing liquidity in the system through the most controversial and undesirable ‘Quantitative Easing’ or in plain words ‘Printing of Money’.
2. In order to boost investment, maintaining negative or ridiculously low interest rates.

Since fortunately or unfortunately the US continues to be the dominant global power, her actions, including those of the Federal Reserve impact the world economies and financial markets, including the Indian stock market as follows:

1. Excess Liquidity: Though meant for boosting domestic investment, cash invariably flows out and floods world markets. This results in a lot of money chasing a small number of stocks and other financial instruments. As per the latest study published by ‘Value Research’ an incredible 40% of the free floating shares of the Indian stock market is held by Foreign Institutional Investors or FIIs. This in-turn drives up valuations to absurdly high levels, making many goos stocks unaffordable to value investors.
2. Maintaining low interest rates for long periods of time adversely impact the interest incomes of majority of common population - ultimately affecting internal savings and investments, which was the goal of the measure in the first place! Additionally it aids the flow of money from the US to global markets, especially emerging economies like India, in search of better interest rates and other investment returns.

In this overall scenario, in the light of signals emerging from the the US economy that it is strengthening and realising in hind sight that the stimulus measures are hurting the economy the Federal Reserve is attempting a course correction by restoring healthy interest rates gradually.

Having covered the basics and understanding the background let us now address your question in the following paragraphs.

1. An increase in interest rates by the US Federal Reserve will have the impact of reversing the outward flow of liquidity. The FIIs will find it little more attractive to invest in their own home country. As a result they start selling their holdings in the world markets, causing a fall in stock prices globally.
2. In addition, an increase in interest rates at home will make the Dollar stronger and conversely the other countries currencies, including the Indian Rupee, weaker. This will force the hands of FIIs to sell immediately, as otherwise they will face a double loss:

• A loss on sale that is certain to arise by selling latter in a falling market.
• The currency exchange loss; when the Indian rupee depreciates, rupees 68 will fetch one dollar today will fetch less than a dollar after a week.

In the end, when the Fed increases rates, global markets will fall and liquidity in the global markets will reduce drastically. There is no doubt abiout this.

Real impact of market correction 

Is such a steep fall or deep correction of the Indian Stock Market good? Yes, it is really very good for the investors. Please note that excess liquidity chasing the small available floating stock has driven-up the valuations to unreasonable levels. While prudent investment guidelines prescribe a PE Ratio of 10 based on past five years earnings, the market today is trading at over 15 of expected, future earnings of the financial year 2016–17. As a result, real investors like you and I are unable to afford to buy shares at these levels.

In conclusion, the Indian stock market will correct on the back of the US Fed increasing interest rates, as and when it happens, and I as a value investor is eagerly looking forward to that day when I will be able to afford to buy many great Indian companies’ stocks like 'Infosys Ltd.', which I cannot afford presently.

Please Note: This is almost a reproduction of the question I had answered on the website ‘Quora’, which I thought could be useful to the visitors to this blog site also.