Anatomy of rate hike cycles – are we done already?

On May 3rd, 2023, the Federal Open Market Committee (FOMC) will announce its decision regarding rates. Despite not releasing a fresh set of economic projections and 'dot plot', Fed Chair Powell will conduct a press conference following the event.

After the previous announcement on April 22nd (in the backdrop of the failure of Silicon Valley Bank), global equity markets rapidly rose on the assumption that the hike cycle is ending. The consensus economist estimate for this meeting is a 25-basis-point hike, with the money market curve factoring in an 85% probability of this occurrence. With this context, this article will focus on
the anatomy of coordinated rate hike cycles, how the RBI has managed the shocks, and how to approach it from an equity investing perspective.


From a fundamental standpoint, there are three notable effects of a coordinated worldwide interest rate hike. Although two of these effects are widely acknowledged, the third may have been overlooked.

The primary and evident impact of coordinated worldwide interest rate hikes is the slowdown of economies. As the common saying goes, "Fed inflation fights typically end in recessions." When interest rates are increased, all four components of GDP (consumption, investment, government spending, and net exports) are affected negatively.

In the event of a recession in the Western world, analysts predict that India's GDP growth could be hit by c100 basis points. The first impact is seen in the reduction of exports in both goods and services, amounting to $254 billion and $422 billion, respectively. Secondly, it necessitates the RBI to raise rates to protect the currency and avoid imported inflation. There are interesting trends here, but more on that later in the article.

Secondly, when interest rates increase, capital tends to flow towards more stable currencies, and historically, the US Dollar has been one of the most stable ones. This results in foreign investors selling all "risky assets," including emerging markets such as India. As a result, both debt and equity capital flee, having a negative impact on India's balance of payments and on equity markets.

Lastly, the most underappreciated outcome of rate hikes is that accidents are prone to happen. During the 2004 to 2006 hiking cycle (when rates increased from 1.25% to 5.25%), the S&P 500 Index rallied 37%, but then came the global financial crisis in 2007. In the current hike cycle, smaller banks in the US, such as SVB, Signature earlier, and now the First Republic, have already created a stressful situation. It is often the last straw that breaks the camel's back. Although nothing may happen when rates are hiked by 5 ppt, an additional increase of 25 bps can lead to the entire system's collapse. When this happens, central
banks adopt a more cautious approach.

Throughout these developments, the RBI has managed the situation exceptionally well. Since February 2022, the Fed Funds Target Rate (FFTR, upper bound) has risen by 475 bps, while the RBI has only increased the Repo rate by 250 bps. As a result, the differential (Repo minus FFTR) is currently at 150 bps, nearly an all-time low. It is worth noting that this differential was over 800 bps in 2013 and close to 400 bps during COVID-19.


In 2021, the US consumer price inflation (CPI) surpassed India's CPI and has remained higher ever since. In terms of real rates (nominal rates minus inflation), the situation is even more favourable for India. The latest figures in India indicate a CPI of 5.6% and a Repo rate of 6.5%, compared to the US's figures of a CPI of 5% and an FFTR of 5%. However, inflation is not the only concern that the RBI is tackling. As stated by Governor Das in the RBI monetary policy speech in 2019, “Post global financial crisis, it has been recognised that price stability may not be sufficient for financial stability and therefore financial stability has emerged as another key consideration for monetary policy, though the jury is still out as to whether it should be added as an explicit objective of monetary policy”.

Financial stability encompasses a wide range of factors, and while India's banking system is the strongest it has been in many decades, challenges could arise on the currency front. India's annual oil imports total about 1.6 billion barrels, and crude oil prices have a significant impact on the country's current account deficit (CAD). At a price of $80 per barrel, the CAD would be $80 billion, equivalent to 2.2% of GDP; at $100 per barrel, it would rise to over $110 billion. In comparison, India's s foreign direct investment (FDI) is expected to be around $40 billion this year, and the country will need to rely on foreign portfolio investments (FPI) to ensure that its balance of payments does not become significantly negative.

The matter is particularly pertinent since within the next year, approximately $280 billion of short-term debt will require renewal. While the number itself may not necessarily be cause for alarm, the record-low differential between the Repo rate and the FFTR means that the rollover may not be as smooth as expected. As a result, the forex reserve has become a crucial guiding policy metric, with the RBI only becoming comfortable only as long as it stays
at an adequate level.

In the current scenario, India's forex reserve stands at $586 billion, which is a comfortable number, covering almost 10 months of imports. However, in case of a perfect storm, such as crude oil prices touching $120/bbl, and only half of the short-term debt being rolled over, along with a significant sell-off in FPI in debt and equity, RBI would be forced to take strong action, similar to what was taken during the period of 2006-08 when the differential rose from just 1ppt to 6ppts.

It should be noted that a worst-case scenario where all these factors happen simultaneously is highly unlikely. Additionally, historical data shows that it takes a considerable amount of time for inflation to decrease. For instance, it took 13 months for inflation to cool off by 2 ppt in 1952, 74 months in 1986, 86 months in 1997, and we are currently approaching 24 months in this cycle.

Assuming the Fed hikes one last time in May (one and done), the prospect of a prolonged period of 5.25% on FFTR upper-bound, $95 billion of quantitative tightening per month, a likely recession in the Western world, and a non-zero probability of RBI intervention for currency reasons are not all supportive factors. Historically, the S&P 500 has bottomed only after the US entered a recession, not before. While the past five weeks have been favourable for Indian equity markets, it is essential to keep an eye on these developing situations.

(The author is Co-founder, Buoyant Capital)

(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of Economic Times)