A 25 basis points rate hike by the US Federal Reserve, which was already priced-in, plus a dovish stance augurs well for risk assets and for emerging markets.
Immediately after the announcement by the Federal Open Market Committee, US bond yields fell and the Dollar Index went down. That will benefit emerging markets like India. The logic is simple: lower US yields equal more funds flowing to emerging markets, and hence a rally in their currencies and equities. With Fed chair Janet Yellen being her usual dovish self, the market is now convinced it has the best of both worlds: strong growth in the US as well as a very slow pace of interest rate increases there, which means a not-so-strong dollar.
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The key to risk appetite for emerging market assets such as Indian equities, therefore, lies in the strength of the dollar. The chart shows the inverse relationship between the two. Since the beginning of this year, as the dollar has weakened against the rupee, the benchmark Sensex has soared.
With the US Fed rate hike out of the market’s way, the rally in Indian equities would get stronger, driven mainly by liquidity as investors are willing to bet on risky assets for better returns, say analysts. This means that while the Sensex may continue to rise, the rupee-dollar exchange rate would decline, they add.
As a note by Citi Research says, “For now, emerging markets may have a reasonably clear path to outperform over the next few weeks. We expect that this environment will encourage allocations to higher-beta and higher-carry EMs (emerging markets). This should thus allow commodity-linked and equity-flow-driven emerging market currencies to outperform.”