The ongoing discussions of sooner rate hikes by the FED has increased the volatility of the stock market. To understand lets consider what happens when interest rates are hiked.
- Carry Trade unwinding – A intermarket Carry trade is a trade where in FII / FPI borrow money at lower interest rates in USA at USD Rate ( say currently at 0.58% – Annual basis ) and they invest this in high growth markets such as India which is very sensitive to FII investors. When interest rates are hiked the borrowing done at 0.58% will now have to be repaid at a higher cost ( say 0.75%) that’s a direct loss of 25 basis points. Also the USD investor is open to USD / INR currency risk too which becomes very volatile when rates are hiked. Hence when FII pull money in anticipation of rate hikes market falls with great velocity.
- An intra market carry trade will cause USA stocks to fall too . Because traders / arbitrageurs who have borrowed money and leveraged their positions will now have to pay higher interest rates , hence they sell stocks and repay their loan while the rates are low.
The stocks that are most sensitive to rate hikes are technology stocks and growth ( high P/E stocks ) . This is simply because the interest rate hikes will lower their earnings and a non-linear computation of the price will lead to a much lower value compared to current price.
WHY DID INFLATION RISE SO MUCH
Two major reasons of inflation across the globe is due to high volume Printing of Dollars and consistent lower rates. The central banks have taken measures to support the economy specially for the lower and middle section of society during the pandemic. But the balance sheet of the FED has swelled to $9 trillion dollars . The FED’s balance sheet was around $4.4 Trillion in 2014 and has seen 100% gains in last 6 years. When the Fed begins to reduce its balance sheet, it will do so in one of two ways. It can sell securities on its balance sheet, or it can choose not to reinvest maturing securities ( known as Tapering of funds)
WHAT TO EXPECT FROM STOCK MARKETS GOING AHEAD
Stock markets generally show initial shockwaves as interest rates increase but quality stocks and unleveraged business bounce back to their median prices quite soon. If you have a portfolio of high beta consumption based stocks its better to add inflation hedge stocks such as non discretionary FMCG stocks and Oil stocks. The tech stocks specially mid cap tech stocks needs to be avoided in these scenarios and one should stick with super large cap companies.
Cost of capital for growth companies will go up and that will reduce their future earnings , this will result in adjustment of the prices in short term.