Fed rate hike signals spook investors, may spur capital outflow

The retreat from risky assets intensified on Thursday after the US Federal Reserve said it is on track to raise interest rates in March and reaffirmed plans to end bond purchases, signalling the end of an era of abundant liquidity.

Investors are worried other global central banks will follow the hawkish shift by the Fed, resulting in capital outflows from emerging markets such as India.

The US central bank had reduced borrowing costs to near-zero in 2020 to counter the economic jolt of the pandemic.

Indian stocks joined a global selloff on Thursday. The BSE Sensex slipped 581.21 points, or 1%, to 57,276.94. The National Stock Exchange’s Nifty index shed 167.80 points, or 0.97%, to 17,110.15.

Shares fell in other Asia-Pacific markets, too, with Japan’s Nikkei 225 shedding 3.11%, South Korea’s Kospi 3.5%, Hong Kong’s Hang Seng 1.99% and China’s Shanghai Composite 1.78%.

On Wednesday, US central bank chief Jerome Powell pledged a sustained battle to tame inflation. Subsequent interest rate increases and an eventual reduction in the Fed’s asset holdings would follow as needed, Powell said, while officials monitor how quickly inflation falls from current multi-decade highs back to the central bank’s 2% target. Much was left undecided, he told reporters after the end of the Fed’s latest two-day policy meeting, including the pace of subsequent rate hikes or how quickly officials will let its massive balance sheet decline.

Indian bond yields spiked while the rupee struck a one-month low on Thursday. US two-year bond yields rocketed to 23-month highs, and the dollar busted out of its recent range after the Federal Reserve stuck to plans for an interest rate rise in March and Powell warned about inflation. The markets feared that the central bank could be more aggressive in its monetary policy to curb inflation.

“Hawkish US Fed commentary, rising crude oil prices, and foreign institutional investors selling were the major reasons for the negativity in the market,” said Siddhartha Khemka, head-retail research, Motilal Oswal Financial Services Ltd.

Investors fear that following the Fed meeting, the FII sell-off in equities may become aggressive as a rate hike in the US typically makes emerging markets assets less attractive. In January alone, FIIs were net sellers of Indian shares worth $2.2 billion, while continuously draining out funds in the last four months. FIIs have sold Indian equities worth $6.97 billion since October 2021. However, markets still have support of domestic institutional investors’ money amounting to ₹12,039.76 crore in January..

“Market participants fear that monetary policy tightening to tame high inflation may prompt foreign investors to pump out liquidity from emerging markets,” said analysts at ICICI Direct. The brokerage said the dollar index may continue its positive bias as the US Fed signalled aggressive monetary tightening. It feels that Indian currency may depreciate further to 76.30 against the dollar amid persistent FII outflows, a strong dollar and elevated crude oil prices.

Oil rose on Wednesday, touching $90 a barrel for the first time in seven years, as tight supply and rising political tensions between Russia and Ukraine added to concerns.

According to Madan Sabnavis, chief economist, Bank of Baroda, the Reserve Bank of India has to take a call on the rewinding of liquidity, and the Fed’s long-term guidance could be taken as a template by the monetary policy committee for consideration.

“We have high inflation and uncertain growth just like the US. The market is demanding higher yields, and the question is how long can the RBI hold on to the present stance,” he said.

Analysts at BofA Securities feel that the Fed is likely to hike rates more than the market is currently pricing. “We still think the market will likely price 6-7 hikes this year and encourage clients to position as such. We also expect the market will continue challenging the Fed towards a 50 basis points (bps) hike in March. If the market prices a 50 bps hike in March, we expect the Fed will follow it given their current “humble” and “nimble” approach to setting policy,” BofA Securities said in a note on 26 January.

Reuters contributed to the story.