The US Federal Reserve is likely to begin its long-awaited easing cycle at its September 18 meeting, where the Federal Open Market Committee is expected to decide on reducing short-term fed rates by 25 basis points to a range of 5.00-5.25 percent.
A Fed rate cut means lower returns on US debt instruments and a reduced cost of funds for borrowers. Theoretically, this kind of situation leads to capital inflows into emerging markets like India.
RBI Governor Shaktikanta Das has said this week that the decision on interest rate softening will be guided by the long-term inflation outlook, rather than any short-term monthly data. The six-member Monetary Policy Committee is set to meet from October 7 to 9 to take a call on interest rates. It is most likely that the RBI will hold the repo rate at 6.5 per cent.
Should the US Federal Reserve opt for a significant 50 basis point reduction or maintain a downward trajectory in interest rates throughout 2024-25, there may arise an opportunity for investors to allocate funds to India due to the interest rate differential between the US Fed and the RBI's repo rate. Consequently, this could pose challenges in managing monetary policy for the Reserve Bank of India.
As a result, the outflows from the US economy could weaken the US dollar, and an increased supply of dollars in India may mean strengthening the rupee against the US dollar, leading to higher foreign exchange reserves.
However, markets don’t always behave predictably. There are various factors, such as the RBI intervening in the forex market to maintain the rupee at a particular level to protect exporters. Let's hear what the experts have to say on this matter.
Rajkumar Singhal, CEO, Quest Investment Advisors, said: "Unless we see clear signs of weakening growth or a sharp moderation in inflation, it’s unlikely that the RBI will feel compelled to align with the fed rate cuts, even if the US central bank reduces rates by 50 or 100 basis points."
"In case there is a 50 basis points cut by US Fed with more in the offing, we believe RBI could change its stance in the following monetary policy towards neutral and keep a close watch on developing implications. Any deeper cuts by fed and other large central banks, might force RBI to prepone its easing but we expect RBI to move gradually in a calibrated manner," said Akhil Mittal, Senior Fund Manager-Fixed Income at Tata Asset Management.
"Currently the US bond markets are pricing in 150 basis rate cuts by the US fed over the course of the next 6 -7 months as US growth is showing signs of cooling off whereas the Indian growth is proving to be much more resilient with RBI flagging off volatility in food Inflation. Given the current Growth / Inflation dynamics we believe that RBI will start cutting rates in CY 2025,"says Puneet Pal, Head-Fixed Income at PGIM India Mutual Fund.
PFI inflows both in the debt and equity markets have been steady and the markets are already pricing in rate cuts from the US Fed and other central banks and as such experts do not see too much volatility in the forex or the Bond markets. "As the rate cuts materialise there is a possibility of a further increase in forex flows which can have a favourable impact on our forex reserves and rupee. Any RBI intervention to absorb the forex inflows can increase domestic liquidity,"says Pal.
Mittal of Tata Asset Management does not think there will be any material impact on the rupee value given that some amount of move is already discounted in markets. "We do not anticipate a major move towards dollar directionally, and hence any impact would be minor. RBI has stated that it intervenes to smoothen unnatural volatility and not directionally, and hence RBI might not commit any large amount of forex reserve in case of directional move. Hence, we do not think RBI will commit more than a couple of percentage points of forex reserves in intervention, "says Mittal. Singhal of Quest Investment Advisors said that foreign exchange rates are typically influenced by interest rate differentials between countries. Looking at the US Fed's recent rate hike cycle, which began in March 2022 and concluded in July 2023, rates were raised by a cumulative 525 basis points.
In anticipation of these hikes, the dollar index (DXY) surged from 89 to 113, though it has since retraced to 101 as markets began pricing in potential rate cuts. During this period, the USD-INR exchange rate has remained relatively stable, with the RBI actively managing volatility by intervening on both sides of the market. The RBI has accumulated approximately USD 160 billion in reserves since October 2022.
"As a result, while faster US rate cuts may logically suggest an appreciation of the rupee, the extent of this appreciation is likely to be moderated by the RBI's continued reserve accumulation. The only potential brake on this accumulation strategy would occur if the liquidity injection from USD purchases starts contributing to domestic inflation pressures,"says Singhal.
"There is no clarity on the extent of rate cut by the Fed. If it is only by 25 bp that will not trigger big inflows into India leading to rupee appreciation. FIIs can be expected to bring big money into India only when the Indian market corrects and valuations become attractive. FII inflows into debt has been happening steadily irrespective of the developments in the equity market," said Dr. V K Vijayakumar, Chief Investment Strategist, at Geojit Financial Services.
"The rupee's lack of reaction to the dollar index's volatility can be attributed to speculative trading being largely absent for the past six months. While the dollar index has fluctuated between $99 and $107, the rupee has remained stable, trading between 82.00-84.00 against the dollar. This stability is also partly due to volatile fund inflows into the capital markets. For significant rupee appreciation to occur, the dollar would need to fall below $99, possibly to $96, at which point the rupee could strengthen towards 83.00. Currently, $99 serves as a strong support level for the dollar," said Jateen Trivedi, VP Research Analyst -(Commodity and Currency) at LKP Securities.