Fed Bears Loom: Why First US Rate Hike In Three Years Can Worsen D-Street's Selloff

Indian equities could face another headwind this week as global investors brace for a potential US Federal Reserve rate hike, with the timing coinciding with the Rs 22,600-crore initial public offering of the National Stock Exchange.

The Federal Reserve is scheduled to announce its latest policy decision on Wednesday after the Indian market hours. Analysts have assigned a probability of more than 50% to a 25-basis-point rate hike by Fed Chair Kevin Warsh, which would mark the first increase in US borrowing costs in more than three years.

Such a move could have implications far beyond US financial markets. Higher US interest rates and bond yields tend to strengthen the appeal of dollar-denominated assets, potentially diverting global capital away from emerging markets such as India at a time when domestic equities are already facing selling pressure.

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Why US Rate Hikes Matter For D-Street

A higher Fed policy rate could push US Treasury yields further upwards. The US 10-year Treasury yield has already risen nearly 7% over the past month and was close to the 5% mark as of September 11.

A move above 5% would be particularly significant. The 10-year US Treasury yield remained above 5% only briefly in October 2023, while the previous breach came in 2007, roughly a year before the collapse of Lehman Brothers.

US Treasuries are considered the global benchmark for risk-free returns and are widely used to price financial assets. As yields rise, investors can demand higher returns from riskier assets, including equities in emerging markets.

For India, this creates a potentially difficult combination of higher global funding costs and weaker foreign investor appetite. Foreign Institutional Investors have already sold more than Rs 14,400 crore worth of Indian equities over the past two weeks, adding to pressure on domestic benchmarks.

The bigger concern is not merely the Fed hike itself but where US Treasury yields settle afterwards.

Until September 11, the US 10-year yield had averaged 4.41% this year, its highest average since 2007. The benchmark has crossed the 4% level on only four occasions over the past two decades.

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At 5%, US government bonds would offer investors an unusually attractive risk-free return. That could make emerging-market equities comparatively less appealing, particularly for global investors who assess returns after accounting for currency and risk.

The impact can be seen through the earnings yield gap. This measures the return investors theoretically receive from equities relative to the risk-free return available from government bonds.

Based on June-quarter results, the S&P 500's earnings yield stands at around 3.82%. With the US 10-year Treasury yield at 4.97% on September 11, the earnings yield gap was negative by around 115 basis points.

Such a negative gap is unusual for a mature developed market such as the US. If Treasury yields move decisively above 5%, the gap could widen further, forcing investors to make even stronger assumptions about future corporate earnings growth to justify holding equities.

India's earnings yield gap is wider, although the domestic market has the cushion of relatively robust economic growth and comparatively cheaper valuations.

Based on the Nifty 50's closing level on September 11, the index's price-to-earnings ratio stood at 19.8, implying an earnings yield of around 5.05%. Against a US 10-year yield of 4.97%, this translates into a negative earnings yield gap of around 197 basis points.

This means Indian equities are not immune to the global repricing of risk. Even though India's growth outlook and domestic liquidity can provide some insulation, a sustained rise in US bond yields could make foreign investors more selective about allocating capital to Indian stocks.

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