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With lot of noise around recent Fed rate hike by 25 bps, investors in India are still in dilemma, what does this hike mean to us ??? How it is going to impact us ??? Is it something to panic about ??
Well this article is all about answering these answers from the very basics :


What does Fed Rate hike actually mean ?

US Fed is the central bank of US (like RBI in India), hike in rates means raising the rate of Interest at which Fed lends and borrows from/to the banks in US. This means eventually the rate of borrowings in US increases and so do the rates offered on FDs and Bonds.

Why the Fed raised the Interest Rates ?

In 2008, while the US economy was facing crisis, Fed in order to stabilize the economy slashed the interest rates to increase liquidity in the economy. In simple words, lower interest rates means loans available at cheaper rates, increase in purchasing power of Individuals & Corporates and therefore creating a demand in the economy. 

How does it affects India & other emerging economies ?

In order to understand this, you need to understand the link between currency and interest rates. In general, emerging economies like India have higher inflation and higher interest rates than developed countries like US and Europe. For example, the interest rates in India right now are around 7–8%, inflation is 5-6% whereas both interest rates and inflation in the US are close to 1-1.5% .
So a lot of financial institutions raise/borrow money in the US on low interest rates in dollar terms and then invest that money in government bonds of emerging countries such as India in local currency terms to earn higher interest. Even after taking into account the depreciation of the local currency due to higher inflation, the investors still earn more than what they could have earned had they just kept their money in the US bonds.
Now you can imagine what happens when the US raises its domestic interest rates. The difference between interest rates of emerging countries like India and the US decreases, thus making India less attractive for the carry trade. As a result, some of the money (the most risk-averse money amongst all carry traders) exits India and flows back to the US. These investors are selling their Indian investments, converting the rupees they get from the sale to US dollars and sending it back to the US i.e. the demand for dollars has increased while the demand for INR has decreased in the forex market. Result - dollar increases in value while INR depreciates.
The effect on the stock markets is not as direct but more of a cascading effect. The biggest financial institutions (those that hold trillions of dollars in total) are global asset allocators - they invest in everything (stocks, bonds, currencies etc) and every country (India, US, China etc) in proportion to its attractiveness and risks. US bonds are the safest investments on the planet so they form the basis of judging everything else. Whenever the expected returns from US bonds change, everything else gets re-calibrated according to that. Now because of the Fed rate hike, the interest offered by US bonds has increased so everything else has become slightly less attractive in comparison. This will trigger some re-allocation from other investments to US bonds. This implies outflow of some money from Indian equities to US bonds for these institutions to match their new target allocations.
However, the stock markets are primarily dependent on the GDP growth outlook for the country and after a possible short-term decline due to these outflows generally get back to behaving according to the growth expectations .

What is the impact of depreciation of rupee ?

Imports like crude oil becomes costlier. therefore leading to increase in Inflation. This would effect RBI policies as we  may now experience lower number of rate cuts. Whereas, it is beneficial for the Indian Exporters, therefore Indian IT companies and Pharmaceutical companies are likely to be benefited.


Conclusion

Although India will be affected by the Interest rates, the major stock market driver is our GDP, with a rate of  more than 7% , India will be least impacted as compared to other emerging economies. In simple words, India will remain the favorite of the Institutional investors and therefore any further rate cuts will only cause hiccups for a shorter term, which investors should take as a opportunity.

Thanks !!!


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well done.. very well explained in such a nut shell. keep doing great work☺️

Great Article ...keep up the good work..!!

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