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Fed set to break the lift-off dithery

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Mr.Dhananjay Sinha

Head of Research and strategist.

09 Dec 2015

The latest testimony of Federal Reserve’s chair, Janet Yellen’s testimony to The Economic Club of Washington is little short of a confirmation that Fed rate lift off is imminent i.e. bringing an end to the 6.5 years of near zero rate interest rate policy (ZIRP), in the upcoming FOMC meeting on Dec 15-16. Contrasting the Fed’s earlier ambivalence on conditions prevailing in the labor market, prospects of economic growth and position on price stability, Yellen’s current assessment carries far greater clarity. For instance despite her prognosis that China would be sustaining low growth, there is little reference to Fed’s earlier concerns on eruption of market volatility in the EMs and particularly China, which prevented the lift-off in September. From a cyclical standpoint few things that are noteworthy First, Yellen corroborated the moderate pace of GDP growth this year at 2.25% and the expansion phase since the 2008 crisis has been sufficient to nudge the residual slackness in the labor market and drive it towards the goal of maximum employment. Yellen also brings to the fore the solidity of US growth momentum, which she underplayed in September with a view to look for further evidence to enhance Fed’s confidence. “Fundamental factors supporting domestic spending” will continue, while global factors that have been a drag till now will recede next year as number of EMs have adopted counter-cyclical fiscal and monetary expansion to boost their growth. Drag from fiscal compression in the US in earlier years will recede, making way for positive effect from government purchases going forward.Second, on the objective of price stability while the core PCE inflation remains below Fed’s target of 2%, averaging at 1.25%, Yellen’s estimate of underlying inflation, stripping out the impact of import price deflation is higher at 1.5% to 1.75%, i.e. marginally lower than its target. It is also in-line with my estimate of 1.7-2%. Going forward, further reduction in labor market slackness and stabilisation in global commodity prices will push up core inflation towards 2%. There has also two critical elements signifying a big shift in monetary policy perspective of the Fed. First, further delay in start of normalisation process is now seen as a risk to abrupt tightening later on, which can be disruptive for economic recovery and financial markets; it can potentially push the economy into recession again. Yellen admits that up till now the Fed was cautious despite “appreciable improvement in the labor market” as it earlier thought “we can respond more rapidly to upside surprises to inflation, economic growth and employment than downside shock”. Second, Yellen also deliberated in detail that the neutral fed fund rate (non-observable rate, which is neither expansionary nor contractionary) was dragged down earlier due to persistent economic headwinds since the 2008 crisis. But those factors are expected to recede thereby gradually moving the neutral fed fund rate higher over time. Rising neutral rate would increase the negative interest rate gap (actual – neutral fed rate) for any given level of actual fed rate, thereby requiring a quicker pace of hikes. As per the Fed, the long term equilibrium for Fed rate is estimated at 3.5%, much higher than the current fed rate at 0-0.25%.December lift off will likely be followed by series of gradual hikes and hence the focus will shift to the pace of future rate hikes. Importantly, we are likely to see intensive tracking of neutral fed fund rate, which is likely to rise along with hikes in fed rate. Fed will likely kick off the normalisation process on Dec 16th with a 25bp hike and follow it up with a 75bp hike over the course of 2016 with an aim to reach 3.0-3.5% over the longer period.Fed’s exit can pose risk for EM flows, particularly portfolio flows, especially given the backdrop of the sharp deceleration in EM’s GDP and earnings growths. Incremental data on FII flows over the past 8-9 months corroborate this view. Receding excess global liquidity, following Fed’s normalisation in the backdrop of global rebalancing could lead to a) further depreciation in Chinese yuan and emerging market currencies, b) Decline in EM investments in US treasury resulting in upward impulse on yields and c) support US fed rate normalization. Retrenchment of excess global liquidity is finally realigning the conflicting signals from multiple asset classes. EM equities will be exposed to complications arising from a) US rate normalization, b) Still exuberant valuations in India notwithstanding earning downgrades sustaining for six years, c) Growth sensitive EMs like India trading more expensive valuations (growth adjusted) than developed markets like US and d) Narrowing growth differential between EM and DMs. RBIs foreign exchange reserves can also diminish, thereby impinging upon money supply and rate easing cycle. RBI’s current status quo stand can prolong. Gsec curve bear steepening can sustain with firmer long end yields; expect 10-yield hardening further to 8% after dipping temporarily to 7.5% following the 50bp cut in RBI’s repo rate in Oct’15. Strength in US dollar value has continued on expected lines with USD major currency index rising beyond 100. This will extend downside risk to EM currencies. We maintain INR/USD weakening bias with a near term target of 68-70.