Indian Economy, Trump and Much Ado About US Fed Rates

New Delhi: Trump’s resounding win did not just add US$12 billion to Elon Musk and caused a broader rally across the US equity markets. One may justify the optimism due to the expected policy changes in stocks, but the subject that is less talked about is the rates. US government bonds dropped dramatically on the expectation of higher rates and for longer.

For various reasons well known to investors, the US dollar plays an important role in global economics. It is not just the world's reserve currency; it is also the denominator for the price of global assets and the provision of international services. From the valuation of the coal trade between South Africa and Germany to the pricing of offshore IT consulting services between Kenya and India, deals are struck primarily in US dollars. Therefore, the impact of Fed rates is profound and global, but it seems particularly pronounced in India.

The recent debates on Fed rate cuts seem to consume Indian investors and economic strategists. Shockingly, US economists do not seem to give much importance to the Reserve Bank of India’s (RBI) rate cuts. This note is my evaluation of whether US dollar interest rates continue to deserve the same VIP treatment as they have done historically. In my view, in the current context, the Federal Reserve’s monetary policy should be afforded much less significance, and any material reaction to US rate cuts by the Indian capital markets could be misplaced and perhaps result in an opportunity for investors.

Bhumi Chaudhary of Astra Asset Management UK Limited shares here insight here:

What Impact does the central bank’s monetary policy have on capital markets?

Borrowing costs, corporate profitability and consumer confidence and behavior

First, to understand the impact, we should understand how the Central Bank’s policies, particularly the spot rate target, impact the economy. Although there are others, for the purpose of this discussion, I’ll focus on the following key factors:

Interbank borrowing rate: For any large economy with several established banks, the interbank borrowing rate represents the cost of liquidity in the market. It is the main driver against which financing costs are benchmarked. Yields on government bonds and Treasury bills are intricately determined by this rate, and it generally sets the tone for short-term financing costs.

Corporate borrowing cost: The higher the borrowing costs, whether for banks borrowing from central banks or corporations from lending institutions, the greater the friction to growth in the economy by increasing the overall costs of producing goods and services. Higher costs are often either passed on partly or wholly to the consumer, thus tilting lower both demand and profitability for the providers. Lower profitability and lower growth may result in a weaker equity market that, in turn, weakens economic sentiment, resulting in the withdrawal of risky capital from the markets, further reducing the liquidity available for growth

Consumers' savings: Consumers also tend to save more if they receive more incentives to do so. If the value of money remains the same year to year, then consumption now is almost always preferred to consumption later. This results in a further reduction of money invested in both equity and debt securities. The poorer economic sentiments as a result of this strong cycle often put fairly dramatic brakes on GDP growth in the affected country, and thus, increasing interest rates is not a tool used by central bankers unless the economy overheats, causing inflation, potential economic bubbles, etc.

But why does the US Dollar Rate impact the Indian Economy?

Foreign investments, Global Assets financing cost and Rupee-Dollar exchange rate

Not only is the US the largest exporting partner for India, but it is also the third largest source of equity foreign direct investment (FDI) in India. The current annual equity inflow from the US was US$ 5bn in FY 2024, representing 9% of the equity FDI in India. Moreover, the US represents ca. 18% of India’s total exports between 2017 and 2021.

Like any investor, US investors assess the yield pickup from investing in a safe asset versus a risky asset. As an investment in an emerging market (EM) (despite being one of the largest, behind China), India is considered risky by US investors compared to US government bonds (risk-free), US corporate bonds (less risky), or US equities. If they receive lower yields from US investments, investors are more likely to search for higher yields in EM and consider making direct investments in EM, including India. The higher the investments in capital markets, the higher the demand, and hence, the higher the market capitalisation attained for Indian assets. A marginal increase in the FDI can, therefore, lead to a significant increase in market capitalisation since marginal demand drives marginal price.

A higher Fed rate also weakens the rupee against the US dollar, and that may result in a higher purchasing cost for US dollar-based assets, such as oil, that are priced in the global markets. A substantial portion of US dollars spent is buying oil in the global market. Any other imports, including a subscription to Chat GPT or Netflix, also cost more in rupees. This also gives rise to direct inflation in India, as companies cannot stomach higher costs and, therefore, pass them on to consumers. Higher inflation in India would result in tightening monetary policy and, therefore, is also entirely tied to US rates.

Will there be a significant US dollar rate cut? 

Despite the post-election euphoria, there would be some, but not a lot, and not lower for much longer.

The past decade has seen extraordinary action to keep interest rates low for longer globally, and this has resulted in ‘cheap money’ in the developed market that gave rise to

• ✓ High leverage and;

• ✓ Market expectations of low interest rates being the new normal.

“Current inflation in the developed economy stems much less from loose economic policies than from the helicopter money dropped during COVID and subsequent reduction in global efficiency. This is what has resulted in extraordinary wage inflation and historically low global unemployment rates,” says Anish Mathur, Chief Investment Officer of Astra Asset Management UK Limited, London.

Therefore, despite a rapid increase in interest rates, developed markets have not been fully able to tame inflation. The market expected that inflation would be controlled, leading to a consensus that there would be six cuts in the past twelve-month period. Clearly, we have not seen that.

Ken Brougher, Head of Private Debt at Astra Asset Management, says, “Through 2023–24, we maintained our opinion that the rates are likely to remain higher for longer. Now, although we expect the Fed to cut, we neither expect these to be very deep nor for very long. We do not expect the 10-year US government bond yields to drop below 350 bps or increase above 450 bps in the medium term.”

Why has the impact of US monetary policy diminished for India?

Inverted Yield Curve, Non-Dollar Trading Partners, Long-term Foreign Investors

There are various reasons today why the impact of the US Fed’s action has significantly diminished (albeit it has not disappeared). I list the few more important ones below.

Direction of capital flow

Indian capital markets are quite sensitive to inflows and outflows of foreign direct investment in Indian equities, historically driven by the yield on US dollars. As rates go down, investors increase allocation to Indian markets, and as they go up, they reduce the allocation and repatriate capital back to US markets. However, this has systemically changed over the past few years.

Short-term global investors  

These investors look at the global capital markets to find relative value, but lately, the focus has mostly been on the US equity markets. The S&P500 and Nasdaq have performed so well over the past decade that there has been a continued inflow from many sources of capital to passive equity ETFs. The relative returns generated by US equity markets have not just beaten perhaps every other global market (at least when denominated back in US dollars), but, in absolute terms, these returns have been very satisfactory for most speculative US investors that target mid-teens annual returns. Investors, therefore, do not see the attraction of investing in foreign capital markets, as they are able to achieve this level of return on their home turf. In any event, the expected pick-up in yield is minimal against a backdrop of a significant increase in exposure to market and currency risks. The lack of scalability or opportunity has also not been very appealing for speculative global investors. They have thus not played a significant role in Indian capital markets and have tended to stay out of it. The current short-term rate changes will continue to remain unnoticed by speculative allocators in India.

Long-term global Investors

The FDI that India has seen is, therefore, from those institutional investors who seek to diversify risk through their investments in global capital markets and see long-term growth potential in India. India is probably one of the largest markets in the world, and it has significant areas remaining for market expansion. It has a rapidly increasing middle-class population with ever-increasing purchasing power that contributes increasingly to global consumption. The American/global long-term investor, therefore, does not look at the short-term change in US interest rates to determine their allocation to India’s equity capital markets. Changes in the short-term rates are not going to change their allocation policy for India.

Inverted Yield Curve

The Indian fixed-income market does compete for capital with the long-term carry-on US dollars. However, the peculiar shape and the length of time that the US$ yield curve has remained inverted have created immunity to its impact.

Typically, short-term rate cuts are accompanied by a downward shift of the entire rate curve, i.e., the overnight fed target rate often reduces 10-year government bond yields, but it does so in a normal-shaped upward-sloping yield curve. With the expectation of recession diminishing, the shape of the yield curve would normalise, and for that to occur, long-term rates must not go down. Thus, the expectation that long-term rates will decline with spots is unlikely to come about. Ten-year rates may, in fact, go higher and remain at about 4% or range bound (+/- 50 bps) in the medium term. This at least counters any cut in the spot rate, if not completely diminishing its impact on the long-term carry cost of US dollars. Thus, this also contributes to the reduction of the impact of any Fed rate cut on the capital inflow in Indian fixed-income markets.

India’s Foreign Policy

While the numbers may or may not be estimated accurately, the Indian government has been able to significantly shift the utilisation of US dollars to buy dollar-denominated commodities such as crude oil. Despite the Ukraine war, India has maintained its trading ties with Russia, becoming a significant non-dollar-denominated trading partner for Russia. As a result, US dollar expenditure has been reduced significantly, offsetting the decrease in the demand for US dollars in India. India has also not been impacted (and has, in fact, benefitted) by the restrictions on Russian oil and has been able to source cheaper oil and other commodities. The impact of lower demand for US dollars and the availability of cheaper global commodities has resulted in muted inflation in India, whereas the Western developed markets have had a difficult time taming the inflation beast.

The impact of changes in interest rates, which determine the cost of financing in US dollars, has, therefore, diminished quite significantly for the Indian economy.

China’s relation with the western world

Finally, the current changes in the geopolitical schema have put India in a strong position. When it comes to the destination of investor capital headed out of US shores, China has historically been the only real contender for investors who looked for scale and liquidity in EM and has thus been the largest beneficiary in recent years. However, investors perceive significant incremental risk due to the friction between Western countries and China and have consequently reduced their exposure to Chinese capital markets. In addition, the recent performance of the Chinese capital market has been very poor, causing it to fall out of favour with foreign investors. Analysts’ outlook for Chinese capital markets remains negative, and despite recent government announcements for stimulus in the equity markets, investors remain jittery, and confidence remains very fragile. With Brazil, Russia, and China out of competition, the I of the BRICs will remain a significant beneficiary. Fed hikes or cuts would not change that allocation, as it is largely driven by geopolitical factors.

To Conclude

While policy changes under the Trump administration would have an economic impact that may translate into fed actions, the market prices a bit more, and those reverberate are not going to be felt at the Reserve Bank of India. The political environment in India, however, does.

As Deepali Rana of CNBC India says, “With Modi returning for a third term in government, India provides a stable political environment, low inflation, a sizable market for global growth, and a large English-speaking population, and changes in Fed policy have a diminishing impact on Indian capital markets.”

While the US dollar continues to dominate the global landscape and the impact of changes in the dollar-denominated financing costs will continue to be felt globally, India is currently more insulated than it has been in the past from changes in US Fed policies. Whether it is a trend or a temporary shield created by a unique set of global and macroeconomic circumstances remains to be seen.

About Author:

Bhumi Chaudhary is a member of the Investment Team at Astra Asset Management UK Limited, where she leads sourcing, origination, and credit underwriting for private debt investments across the UK and Europe. With expertise in direct lending, acquisition financing, and refinancing, she takes a sector-agnostic approach to senior and subordinate investments. Previously, Bhumi worked as a credit analyst focusing on US and European mortgage-backed securities, CLOs, and CDOs. She holds a Bachelor's in Commerce (Hons) from Delhi University.