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The biggest external risk the markets are facing, although you wouldn’t really know it by looking at their elevated level, is that of interest rate hikes by the US Federal Reserve. Photo: Mint
The biggest external risk the markets are facing, although you wouldn’t really know it by looking at their elevated level, is that of interest rate hikes by the US Federal Reserve. Photo: Mint

What will be the impact of a US Fed rate hike on Indian markets?

Going by the previous episodes, Indian markets have little to worry

The biggest external risk the markets are facing, although you wouldn’t really know it by looking at their elevated level, is that of interest rate hikes by the US Federal Reserve. Reserve Bank of India governor Raghuram Rajan has waxed lyrical about this risk, as have the Bank for International Settlements and even the International Monetary Fund.

Perhaps a look at previous episodes of interest rate raises in the US might be useful. A recent research note on Asia strategy by BNP Paribas does precisely that. It looks at earlier occasions when the yield on the US 10-year treasury note went up and checks how it affected Asian equities (see chart).

Consider 1993-94, when higher US rates shook emerging markets and precipitated a crisis in Mexico, named the Tequila crisis. After the initial scare, note that the MSCI Asia ex-Japan Index didn’t do too shabbily, rising 22.5%, while the Indian market did even better. And this was despite a 2.5 percentage point hike in the US 10-year bond yield over that short period.

Next, in 1998-2000, when the US 10-year treasury yield went up 2 percentage points, the Asian markets shrugged it off completely. This was the time of the infamous dot-com boom, so the S&P 500 index went up 32.6%, but the Asian markets, which were recovering from the Asian crisis, did much better. The Indian market again performed splendidly.

The period 2003-06 saw US 10-year treasury yields rise 1.8 percentage points. But this was the time of the great boom, which propelled the MSCI India Index up a spectacular 216.9% over the period. Of course, the then Fed chairman Alan Greenspan took good care to ensure that his policy of hiking policy rates in homeopathic doses kept the party going.

While the Fed didn’t hike rates in 2012-13, US 10-year bond yields did move up by 1.5 percentage points during the year on liquidity concerns—the period includes last year’s taper tantrum. This time, the S&P 500 went up 32.9% and MSCI Asia ex-Japan by a much lower 14%. The Indian market, as usual, outperformed other Asian peers, but didn’t do as well as the US.

Going by the previous episodes, therefore, Indian markets have little to worry. BNP Paribas says the denouement after a Fed hike this time will probably be much like the most recent 2012-13 episode. Note that US 10-year treasury yields are currently well below the level they were at the end of 2013, reflecting continuing scepticism about growth. It also reflects the market’s belief that Fed chairperson Janet Yellen has neither the guts nor the inclination to withdraw what used to be quaintly called the punch bowl, but now is much more like crack cocaine.

The BNP Paribas note adds that emerging market flows are not abating despite the rate scare. Rather investors are selling US and European equity funds lately. That explains the market’s lack of concern.

But can the massive doses of liquidity pumped in by central banks really be compared with the previous episodes? Has this ocean of liquidity not led to mispricing of assets? Should yields on Spain’s 10-year government bonds really be lower than on US 10-year treasury notes? In short, the question really is: can we escape a hangover even after such a massive binge?

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