US Rates-For How Long The Suspended Animation?

We look at 3 possible Indian scenarios after the Fed’s September 17 meeting. The best – and our base – case would be a 25bp Fed hike, in our view. While there could be a knee jerk sell off across EMs, India would likely emerge as relative value, given relatively higher growth. Portfolio flows could resume in equities due to risk diversification out of China’s volatile equity market and in bonds with the S&P downgrading Brazil to junk if the RBI hikes FPI G-sec limits. The worst is if the Fed signals October/December action. This would stall capital flows till the winter, given uncertainty about the turnaround in earnings and Bihar poll results on November 8. 

With the RBI likely to wait for FX flows and conduct OMO purchases only in 1Q16, this would likely tighten liquidity at a time credit offtake is already running at a low 9.5%. An unlikely push back to early 2016 may not be as positive for risk on as some think as growth fears could overwhelm comfort about lower rates. On balance, we continue to expect the RBI to cut rates by 25bp on September 29 and hike the FPI G-sec limit by US$5-6bn.  (see, If the Fed hums Come September… 12 June 2015). #1.

September 17 hike: India relative value  The best – and our base – case is a 25bp Fed hike, as our US economist, Ethan Harris, expects. While there could be a knee-jerk sell off across EMs, India would likely emerge as relative value, given support for equities due to volatility in China’s equity market and to bonds with the S&P downgrading Brazil to junk. (see, Brazil to junk: the first to give, the first to take away 10 September 2015). 

India is relative value: India remains relative value although there is a 30bp downside risks to our 6% FY16 growth forecast (Table 1). In fact, India is overtaking Brazil and China to emerge as the second largest EM after China (Charts 1-2).  

RBI to cut September 29: This should support our call that RBI governor Rajan will cut rates 25bp on September 29, with markets pricing the Fed hike in by then and August CPI inflation set to come in at 3.4% on September 14 (Chart 3). (see, India Economic Watch: RBI: Next cut September; 50bp to come 04 August 2015). 

Portfolio inflows would support liquidity: We expect portfolio inflows to turn around to support liquidity if the Fed is behind us. Valuations in equity markets are moderating, although the BSE Sensex is still trading at 15.8x 12-month forward earnings, which is higher than 14.5x long-term average. At the same time, the INR is trading below fair value of Rs55/USD according to our global economists as well as Rs63-64/USD indicated by Gov Rajan. As G-secs are oversold by any macro parameter, we expect debt FPIs to subscribe to our expected US$5-6bn FPI G-sec limit hike (see, Will volatility persist? 07 September 2015). 

US$6bn FPI G-sec limit hike on September 29. We to expect the RBI to raise the FPI Gsec limit by, say, US$5-6bn on September 29 if the September Fed hike is priced in by then or the Fed signals that it will hike from December (Table 2). Gov Rajan has told the August 5 analyst con-call that it would be prudent to see the Fed rate hike through before taking action on the FPI G-sec limits, but at the same time also highlighted that the RBI will not hold back its financial market reforms waiting indefinitely for the Fed to act.