Back to the future: will it be a rerun of 1998 or 2001?

Back to the future: will it be a rerun of 1998 or 2001?

Federal Reserve chairman Ben Bernanke proved on Tuesday that it’s not for nothing they call him “Helicopter Ben". He earned the nickname when he suggested in a speech before he became chairman of the US Federal Reserve that a deflation could always be avoided, if need be, by dropping dollars on the streets from helicopters. “The US government has a technology, called a printing press, which allows it to produce as many dollars as it wishes at essentially no cost," he had added. Few people realized at the time that he would take his own prescriptions so literally.

On Tuesday, the Fed cut its overnight interest rate by 0.5 percentage point to 4.75%. The signal sent out by the bigger-than-expected rate cut to the markets is a simple one—they now have the Fed on their side. That’s why the Fed funds futures are pricing on a 90% chance of Bernanke cutting rates by another 25 basis points at its October meeting and a 60% chance that the Fed funds rate will go down further by another 25 basis points to 4.25% in December.

Nobody knows whether the rate cuts will be enough to stave off a slowdown in the US. The yield on the US 10-year treasury note has hardly moved after the cut. Nor is at all certain that it spells an end to the credit crunch, but what is certain is that it has made taking risks more attractive and has reduced the cost of borrowing. The boom in the equity markets and especially emerging markets in the last four years has had cheap credit as its foundation. Recent increases in central bank policy rates across the world and the credit crunch had led to decreasing liquidity and the worry was that the tide that had lifted so many boats was at last ebbing.

The Fed’s rate cut signals the resurgence of that tide. That’s the reason stocks, commodities, oil and gold are all up. Risk premiums on emerging market bonds have tightened sharply. Lower rates in the US have led to a flight from the dollar and the US dollar index is at a 15-year low.

Where will the liquidity go? Will it go to US stocks, with all the uncertainty still hanging over the economy and banks and financial institutions yet to come out of the woods? Or, should it go to emerging markets such as India, with their high rates of growth, lack of exposure to the subprime epidemic and strong domestic demand? With the dollar at multiple-year lows, surely it makes sense to buy non-dollar assets. That logic is strong, which is why a JP Morgan Chase & Co. strategist said in Mumbai last week that although the Fed may cut rates to boost the US economy, the money may not flow to the intended beneficiaries but may well end up in emerging markets. If, as many observers have warned, Bernanke’s decision to keep the party going could lead to another huge bubble, that bubble could very likely be in emerging markets.

How will Indian markets fare in this scenario? Now that the moves of the Reserve Bank of India (RBI) to cool the economy are paying off, won’t that hurt the markets? Earnings growth, after all, has already started to slow. But then, the market already knows all that, including the likelihood of an early election.

Much depends on whether the future plays out like 1998 or 2001. Consider what happened in 1998. In that year, after the Asian crisis, the Russian default and the bailout of Greenwich, Connecticut-based hedge fund Long Term Capital Management, the US cut rates by 25 basis points each time on three occasions between September and November. That sparked a huge rally in equities. The Sensex too rallied from 3,102 points at the end of September to 4,898 by August 1999.

The difference, however, is that the Sensex rallied from a price-earnings (PE) multiple of 11.5 in September 1998 to a high of 29.4 in June 2000. This time, the Sensex was already at a PE multiple of 21.16 as of last Tuesday. But then, the gross domestic product growth rates in 1998-99 and 1999-2000 also were much lower at 6.5% and 6.1%.

While markets soared when the Fed cut rates by 50 basis points in January 2001, they soon fell back. The Sensex rallied from 3,972 at the end of December 1999 to a high of 4,462 in February before falling back. The difference between 1998 and 2001: US GDP growth was 4.2% in 1998 and 0.8% in 2001. This time, the US economy is much weaker than it was in 1998. This time, there are no dotbombs either.

It will take a while to figure out whether the rate cuts are having the desired impact on the US economy. At least till then, the liquidity unleashed consequently should ensure that markets rally.

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