Over the past few months there have been a lot of speculations on the fact that a fed rate hike is coming soon as the economic data of US improved. Less number of people filing for unemployment benefits, good GDP growth in the past quarter gives way for a fed rate hike by around 0.25-0.5 percentage. In this article we discuss what exactly are the fed rates and how does it impact the world economy, especially India.
What are fed rates?
Just like RBI decides monetary policy of India, US central bank known as the US federal bank is responsible for deciding the monetary policies of the US. Among its various functions, one of the major task federal bank does is decide the Federal funds rate. As we know that banks borrow or lend money to each other whenever there is shortage or excess supply of money in their vault. The interest rate which they charge or have to pay for the lending is known as federal funds rate. This fed rate is decided by the US Federal Bank in a meeting which usually occurs 8 times in a year. Last time this meeting happened December 16th, 2015. By reducing the fed rate, central bank can encourage lending or borrowing, and the liquidity in the economy increases. On the contrary, when the central bank sees that the economy is growing, people are getting jobs, they can increase the fed rate as people would be comfortable to pay back the loans with interests.
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How does fed rate hike/reduction happen?
Suppose, everyone in the world is given 10,000 $ in cash. You wouldn’t feel richer. Would you? This is because since everyone has the same amount of money, you don’t get any extra benefit as the value of the money would decrease. A similar concept is used here. When the federal bank wants to reduce the fed rate, it does so by buying the government securities ( T-bonds issued by the government). This would lead to supply of cash in the hands of banks. This would encourage them to lend this money to the needy bank at a cheaper rate. Conversely, when the federal bank wants to increase the fed rate, it does so by selling the government securities for cash. This would lead to banks having less money in hand to lend. Consequently interest rates go high.
Its impact on world economy?
Rise in the interest rates could mean higher debt repayment of the loans granted by the banks. This would put pressure on the companies which loaned the money in dollars, putting Asian and European markets in risks as compared to US. On the contrary, the companies which are exporting goods to US would be happy because of strong dollar. They would be getting more money in dollar terms when exporting to US. Example, Chinese companies would grow richer as they export a lot to US. Even Indian pharma companies like Sun pharma would shine. As the interest rates increases, it becomes expensive for companies to pay back the loans. Interests on loans would eat away the profits and make the balance sheets look dirty. This would impact the companies stock, as it might take a plunge. However, mind you interest rates are not the only factor affecting stock prices.
Impact on India?
The sentiments of the markets in Emerging countries which includes India would hurt. Since, the dollar would become stronger, investors around the globe would pull money out of these countries and invest in US which offers higher interests. FIIs have been recently showing signs of outflow from the market since the past few months. Since the rupee would become weaker with respect to dollar, it is anticipated that net import bill will increase as most of the trade happens in dollars. Though, we cannot comment on the trade amount or sales but it is expected that the net value of imports would increase because of depreciation of rupee.
When we talk of Indian companies, it could be very beneficial to the ones which exports services or drugs. For example IT companies like TCS or Infosys could gain because they are earning in dollars from their clients. Even drug makers like Sun Pharma or Dr reddy’s which earn half of their revenue from US would outperform leading to high valuations of their stocks.
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Understanding What happens When the Fed Increases Interest Rates
The recent rise in the Fed funds rate will likely cause a ripple effect on the borrowing costs for consumers and businesses that want to access credit based on the U.S. dollar. That has an increasing impact across numerous credit categories, including the following:
- The Prime Rate: A hike in the Feds rate immediately fueled a jump in the Prime rate, which represents the credit rate that banks extend to their most credit-worthy customers. This rate is the one on which other forms of consumer credit are based, as a higher prime rate means that banks will increase fixed, and variable-rate borrowing costs when assessing risk on less credit-worthy companies and consumers. Large U.S. banks like JPMorgan Chase, Wells Fargo Company, and Bank of America raised the prime rate to 3.5% from 3.25%, which had been the rate since 2008.
- Credit Card Rates: Working off the prime rate, banks will determine how credit-worthy other individuals are based on their risk profile. Rates will be affected for credit cards and other loans as both require extensive risk-profiling of consumers seeking credit to make purchases. Short-term borrowing will have higher rates than those considered long-term.
- Savings: Money market and credit-deposit (CD) rates increase due to the tick up of the prime rate. In theory, that should boost savings among consumers and businesses as they can generate a higher return on their savings. However, it is possible that anyone with a debt burden would seek to pay off their financial obligations to offset higher variable rates tied to credit cards, home loans, or other debt instruments.
- U.S. National Debt: A hike in interest rates boosts the borrowing costs for the U.S. government and fuel an increase in the national debt. According to calculations by the Congressional Budget Office and Dean Baker, a director at the Center for Economic and Policy Research in Washington, the U.S. government may end up paying up to $2.9 trillion over the next decade as the Federal Reserve slowly increases interest rates.
Understanding what remains Unaffected When the Fed Increases Benchmark Interest Rates
- Auto Loan Rates: Auto companies have benefited immensely from the Fed’s zero-interest-rate policy, but rising benchmark rates will have an incremental impact. Surprisingly, auto loans have not shifted much since the Federal Reserve’s announcement because they are long-term loans.
- Mortgage Rates: A sign of a rate hike can send home borrowers rushing to close on a deal for a fixed loan rate on a new home. However, mortgage rates traditionally fluctuate more in tandem with the yield of domestic 10-year Treasury notes, which are largely affected by inflation rates. Currently, inflation levels remain low and recent, significant purchases of conservative vehicles like the 10-year in a high-risk market keep these yields down.
Understanding What Decrease When the Fed Increases Interest Rates
- Business Profits: When interest rates rise, that’s typically good news for the profitability of the banking sector, as noted by investment giant Goldman Sachs. But for the rest of the global business sector, a rate hike carves into profitability. That’s because the cost of capital required to expand goes higher. That could be terrible news for a market that is currently in an earnings recession.
- Home Sales: Higher interest rates and higher inflation typically cool demand in the housing sector. On a 30-year loan at 4.0%, home buyers can currently anticipate at least 60% in interest payments over the duration of their investment. Any uptick is surely a deterrent to acquiring the long-term investment former President George Bush once described as central to “The American Dream.”
- Consumer Spending: A rise in borrowing costs traditionally weighs on consumer spending. Both higher credit card rates and higher savings rates due to better bank rates provide fuel a downturn in consumer impulse purchasing.
Which Stocks Perform Best When Interest Rates Rise?
Although profitability on a broader scale can slip when interest rates rise, an uptick is typically good for companies that do the bulk of their business in the United States. That is because local products become more attractive due to the stronger U.S. dollar. That rising dollar has a negative effect on companies that do a significant amount of business on the international markets. As the U.S. dollar rises – bolstered by higher interest rates – against foreign currencies, companies abroad see their sales decline in real terms. Companies like Microsoft Corporation (MSFT), Hershey (HSY), Caterpillar (CAT), and Johnson & Johnson (JNJ) have all warned about the impact of the rising dollar on their profitability, according to CNN Money.
Rate hikes are particularly positive for the financial sector. Banking stocks tend to perform favorably in times of rising hikes, according to Claudio Borio, the head of the monetary and economic department at the BIS. Borio says financial companies favor high-interest rates due to “the positive impact of being able to earn income by lending money out for higher rates over time is bigger than the hit of defaults and income that doesn’t carry interest.” Shares of large banks like JPMorgan Chase & Co. (JPM) and Goldman Sachs Group (GS) both surged on the day of the Fed’s announcement. However, both have recently declined due to exposure to weakness in the Chinese markets. Regional banks like SunTrust Banks (STI) and BB&T Corp. (BBT) also showed similar boosts in stock price after the Fed’s announcement.
According to Goldman Sachs, companies that are rated as “quality stocks” tend to outperform the market over the three months after the Fed increases interest rates. These stocks are defined by strong balance sheets and have beaten the markets by an average of 5% following the rate increases 1994, 1999, and 2004.
Source – Inputs from Investopedia
