FED’s 3-Pronged Strategy and Global Economic Developments: A Short Note
The FED is trying to tame inflation, and, in the process, it has increased interest rates by 75 basis points twice. August-2022 inflation number has come at 8.3%, with stubborn core inflation of 6.32%. The FED is scheduled to meet on 20-21 September-2022 and under the backdrop of the August-2022 inflation data market is abuzz with predictions whether rates would go up by 75 or 100 basis points. Increasing interest rates is just one of the tools available. As we see, at the present, the FED is using the following 3-Pronged Strategy to tame the inflation, which could spook markets and commodities prices going forward:
Continue increasing the interest rate and keep it at an elevated level for a longer period
Though markets can keep debating whether rates would reach at the level of 4.25-4.50% or not, it is not the interest rate only which is at play.
Doubling the speed of quantitative tightening (QT)
The FED started the QT program from the month of June-2022 and in the months of June, July, and August USD ~47.5 billion per month of liquidity was drained out. Now from the month of September-2022 this speed is going to be double, i.e., USD ~95.0 billion will be drained out every month from the system[1]. Liquidity tightening coupled with increasing interest rates will have greater impact.
Keeping USD strong
At present dollar index is at ~110, strong dollar helps to keep commodities prices in check and reduces the international borrowings.
Going forward one would expect financial and commodities prices to soften. This would also have an adverse impact on corporate earnings, and we expect earnings growth to slow down in coming quarters, which could be negative trigger for the stock market.
While we expect commodity prices to soften, energy prices in Europe have remained uncomfortably high. To manage the adverse impact of higher energy costs on the economy, Europe and the UK have announced USD ~500 billion subsidy programs[2], which could go up further depending on the needs. The availability of reasonably priced Natural Gas (NG) is going to be crucial for Europe in the coming months. Though Russia has drastically cut down gas supply to Europe, it is selling NG and LNG to China[3] and China, which is an LNG importer is exporting LNG to Europe.
Considering the nature of energy crisis in Europe, it likely that some of the European nations would come closer to economic trouble sooner than expected and that may trigger some serious efforts to end the war. The German economy is also getting affected due to the deteriorating global economic environment and the energy crisis.
In the months of July and August the resilience of Indian markets has come as a surprise. But if we look at Chinese markets and Indian markets together, we find that during the period 01 July-2022 to 03 August-2022 Chinese markets went down by ~9% while at the same period Indian markets went up by ~10%. That indicates some adjustments in fund flow made by fund managers between China and India to cash in on available opportunities.
One-sided market rally and real negative interest rates in India have played a role in increasing the number of demat accounts. Total number of demat accounts reached 10.05 crore at the end of August-2022, while prior to COVID onset, India had ~4.1 crore demat accounts.
Considering the nature of markets, a downward swing, caused by developments in the US and European markets, may have an adverse impact on the first-time investors in the Indian equity markets, particularly the ones who have invested at the peak.
References
[1] USD 60 billion in US Treasuries + USD 35 billion in Mortgage-backed Securities; up from USD 30 billion in US Treasuries + USD 17.5 billion Mortgage-backed Securities; Sources: FEDERAL RESERVE Press Release, July 27 2022 https://www.federalreserve.gov/monetarypolicy/files/monetary20220727a1.pdf & June 15 2022 https://www.federalreserve.gov/monetarypolicy/files/monetary20220615a1.pdf
[2] Source: CNN Business – Price of war UK and EU throw $500 billion at energy subsidies https://edition.cnn.com/2022/09/08/business/liz-truss-energy-price-cap-europe/index.html
[3] China Is Quietly Reselling Its Excess Russian LNG To Europe | OilPrice.com. NG pipeline runs between Russia and China, it has capacity to carry excess NG.
