Thursday, 31 July 2014

FOMC and likely impact on INR


Today India time 11:30 PM, US FOMC (Federal open Market committee) will conclude it’s two day meeting and issue decision on interest rates, monthly asset purchase program (QE) and most importantly issue a statement which will be used to make assessment about timing of rate hike. The monetary policy decisions by FOMC would have significant impact on global financial markets including India and in this brief note we try to predict market reaction on USDINR post FOMC.

The likely decisions
The current Fed fund target rate is 0.00%-0.25% and FOMC will not make any change in the rates. Monthly asset purchase (QE or quantitative easing) by Federal Reserve is USD 35 bn. divided into USD 15 bn. for mortgage backed securities and USD 20 bn. for treasury securities. FOMC meets twice a quarter and they are reducing the monthly purchase rate by USD 10 bn. every meeting and this time they are expected to reduce the overall QE to USD 25 bn.

Assessment of data and events
Federal Reserve’s objective is maximum employment with inflation at 2.00%. Hence they balance their decision on monetary policy after looking at the growth numbers which potentially impacts employment and inflation numbers including wage inflation, core inflation, and personal expenditure inflation. Let’s look at the changes in key factors since last meeting in June 18 –

A. Inflation
Last reading of US inflation released on 22nd July for the month of June was not strong. CPI inflation was only 0.3% compared to the uptick achieved prior month at 0.4%. Core CPI was also only 0.1% compared to 0.3% of May. On 30th July before FOMC decision, PCE (personal consumption expenditure) inflation data will be published and significant change there may sway FOMC decision. However broadly, inflation for now remains low and it is one of the primary reasons why FOMC is not worried about low rates. FOMC has started looking at the wage inflation also which currently is around 0.2% only.

B. Employment
US employment situation has improved with steady non-farm payroll signifying steady addition in number of employed people. Last reading was 288K. The same is reflected in unemployment rate being 6.10%. Another measure of employment is number of people claiming job-less benefit and a consistent decline in such numbers are healthy signs. Four week average of the number is 302K and it has been steadily declining.

C. Growth and Geo Politics
During the last 45 days, geo-political risks have certainly escalated with violence in Palestine, Iraq and Ukraine related tussle between west and Russia after the Malaysian Airlines crash. IMF reduced global growth forecast to 3.4% from 3.7%. US first quarter contraction was -2.9% and hence advance estimate to be released for Q2 on 30th

QuantArt Market Solutions Pvt Ltd.
Research Report – 30 2 th July 2014
July prior to FOMC is critical. Even if the number is stellar 3.00% +, US growth for first half of the year remains almost flat. The housing market showed signs moderation as per the last data as well and so did industrial output. Overall growth concerns have increased since last meeting and that would stop FOMC from making any hawkish comments immediately.

D. Bubble risk
The increasing debate in US policy circle is that of excesses in asset prices thanks to ultra loose monetary policy. Dow touched all time high, issuance of high yield (low grade) bonds or Junk bonds are at all time peak and carry currencies are doing too well. While Yellen mentioned that monetary policy is not the primary tool for containing bubbles, the fact remains that market takes cues from rates and accordingly plays on the risky assets. The domino effect is the scary part when asset prices correct sharply.

Expectation from FOMC statement
Overall we feel, FOMC will continue dovish stance through statement after this meeting citing growth and geo political concerns. However they will note the excesses on asset prices more clearly as risk.

Likely impact on INR
During the last 7 months USD 25 bn. has been invested in India by FIIs with USD 5 bn. in July alone. While India needed the comfort of investor’s confidence and consistent capital inflows, such a strong flow is not a healthy sign and instead a matter of concern. The FII- debt segment investments are nothing but currency carry-trade and to a large extent outcome of loose US rates. In other words the hot money when it goes out will create chaos in global markets including India. However two factors will protect INR from any currency crisis at this stage

1. RBI’s determination to not allow hot money to disrupt Indian financial markets whenever such outflows happen. They have accumulated significant reserves.

2. Significant Improvement in Indian political, macro expectations along with containment of CAD
Overall Assessment

 Either this FOMC or next FOMC is capable of disrupting financial markets though most likely this one will not disrupt markets.

 Considering that RBI is a consistent buyer of USD to mop up reserves and INR has remained steady at 60.00 levels during the period of such inflows, it is reasonable to expect next move of INR towards 61.00 when-ever outflow happens.

 Even though India is better prepared compared to peers to combat the eventual US monetary policy withdrawal, There will be some stress. In other words, INR may not depreciate by Rs 10 but can certainly depreciate by Rs 3-4 during US monetary policy withdrawal.

 However as noted above, chaos is unlikely to start after this FOMC though FOMC statements and comments have become the most important factor to decide the fate of INR going forward. At least more important than many Indian market participants consider it to be.

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