Hold your horses, Fed's not done yet

Equity markets have drawn comfort from signalling by the US Federal Reserve that its rate-tightening cycle may be over. This may appear premature with inflation beyond target, but the Fed is calibrating its policy to the expansionary fiscal stance that is driving up treasury yields. Government borrowing may avert a hard landing for the US economy as consumption is squeezed further. But US interest rates will remain higher for longer and the market reaction may be overdone. Extended hostilities in West Asia could spill over into energy prices and threaten what the Fed sees as a gradual anchoring of inflationary expectations.

The Fed’s newfound dovishness should slow the movement of capital that is seeking safety in US debt. But it is unlikely to reverse its direction. Emerging markets will continue to deal with throttled capital flows, but currency movements should be more orderly now. Central banks everywhere will have to deal with rising US treasury yields, given the size of the supply pipeline. This could speed up the process of de-dollarising foreign exchange holdings. Continued fiscal expansion in the US also has a positive spin-off in raising export demand for emerging economies. Portfolio investments will be stickier in emerging markets that are catering to strong domestic recovery.

India has some insulation from strong domestic consumption and a government-led investment cycle. It is also in the grip of a new cult of equity funnelling unprecedented household savings into stocks. Prospects of the US averting a recession are a positive for its services exports. If Fed chair Jerome Powell pulls off the near-impossible feat of taming inflation without busting the US economy, new tailwinds will drive Indian equity markets. They would emerge from an extended time correction sooner. But it will not escape a spike in short-term volatility.