Interest Rate Cuts and Their Impact on US and Indian Markets

After a long wait, it looks like the time has come for the interest rate to go down in the US.

In the latest meeting, US Fed Chairman Jerome Powell has clearly hinted that the first rate cut can happen in September when the meeting would be held on the 17th and 18th of September. This is something the market has been patiently waiting for a long time.

Now, if you recall, at the beginning of August, there was a high fear of recession in the US, and now suddenly, markets are cheering the rate cuts.

So, the question is: can this interest cut further fuel the ongoing bull rally in the Indian stock market, or are there challenges in the US economy that can result in a correction in their market and have negative consequences on Indian markets as well?

Also, which sectors can react positively after this rate cut news?

In case you are not aware of the impact of interest rate cuts on the stock market, let's take a step back and quickly set the context. During COVID, the US economy struggled badly due to lockdowns.

The unemployment rate surged exponentially, and the US Fed had to cut the interest rate to ensure high liquidity in the economy.

In fact, the interest rate cuts went from 2.5% all the way to 0.25%, resulting in extremely high liquidity as the interest rates were close to 0%. Just imagine getting money at near 0% interest rates!

This resulted in a sharp jump in the Nasdaq, representing the top 100 companies in the US, as well as the S&P 500, which zoomed from COVID lows of 7,000 all the way to 16,500.

A lot of that money from the US also got invested into emerging markets like India. To be specific, between May 2020 till March 2021, FIIs invested a total of ?2.06 lakh crore in the Indian market.

On top of this, retail investors also invested their money, resulting in Nifty zooming from COVID lows of 8,000 all the way to 18,000.

This rally was even crazier at the broader market level. The midcap index zoomed even higher with a 150%+ return, and the small cap index zoomed with more than a 200% return.

However, high liquidity in the US market eventually resulted in high inflation, which zoomed from below levels of 2% all the way to 9%, the highest in 40 years of US history.

Obviously, this high inflation is not good for any economy because everything becomes expensive, and the currency loses its value.

That's what happened in the US—house rents rocketed, energy prices jumped exponentially, food prices increased drastically, and so on.

That's when the US Fed started increasing interest rates in the US, starting in March 2022, when it increased the interest rate from 0.25% to 0.5% and kept on increasing it till July 2023, all the way to 5.5%, the highest rate since 2007.

The ultimate goal was to bring down the inflation below 2% in the US, which it somewhat succeeded in. Inflation started falling from a peak of 9% in June 2022 all the way to 2.9% now, but it took them more than two years to bring the interest rates down.

Remember, inflation in the US is still higher than the Fed's target of below 2%, but the expectation is that it will eventually reach the 2% level.

Now, the catch is that it's not that easy to just increase interest rates and reduce inflation because higher interest rates create massive problems in the country.

First of all, high interest rates sucked out liquidity from the US market, resulting in a 35% correction in Nasdaq between November 2021 and October 2022.

In Indian Market, FIIs started pulling out money big time. Between April 2021 till date, FIIs have pulled out investment worth ?5.88 lakh crore from the Indian market. Just take a second to digest this.

If this was the India of 10 years ago, I would not be surprised if Sensex and Nifty had corrected by 40-50%, and the midcap and small cap indices by 60-70%.

But all thanks to retail investors and their SIPs, DIIs were able to absorb all the FII selling by investing a staggering ?8.8 lakh crore during the same time period. That is the reason the Indian market did face a challenge when Nifty fell 15% between October 2021 and June 2022, but then kept on touching new highs.

Of course, it was not just because of retail investment; the core reason was the resilience of the Indian economy with high growth and lower inflation rates.

Although the catch is that this crazy rally in the Indian market has made the markets expensive, let's be honest about it—especially a lot of pockets in the midcap and small cap segments are very expensive compared to the growth rate.

But this is an unprecedented liquidity-driven rally in the Indian market due to the rise of retail investors as one of the strongest pillars of the Indian stock market.

There's a concern over valuation as well, and the market needs just one reason to book profit. So, the question is: will the Indian stock market continue to rally, or can there be a correction in the Indian market? For that, we need to understand the current state of the US economy.

So, coming to the US economy, yes, the inflation rate in the US has significantly fallen from the peak, and the fall in inflation is a very good sign, but there's a catch. High interest rates in the US for the last more than two years have resulted in a slowdown in growth.

One of the key parameters to gauge economic activity is the US unemployment data. Now, in August, the US market fell 7-8% within a week, and even Nifty fell around 4%. This was because of the fear of recession due to a sharp rise in unemployment in the US.

This chart shows the unemployment data that spiked during COVID, then fell, and now in recent months has jumped from 3.5% all the way to 4.3%. This is not a good sign.

When unemployment rises in the US, it has a snowball effect. People can't afford their mortgages, they can't pay their bills, and economic activity reduces, resulting in a recession.

So, when US unemployment data was out in the beginning of August, it triggered all the negativity with a slowdown in growth.

"So now that the US Fed is planning to reduce the interest rate, won't it result in a fall in the unemployment rate and improvement in the US economy?" Well, yes and no.

The catch is that the US Fed won't reduce this interest rate from 5.25% all the way to, say, 2 or 3% overnight. It will be a gradual process.

The expectation is that in the next meeting in September, the US Fed would cut down the interest rate by a minimum of 25 basis points (0.25%) and a maximum of 50 basis points. Then, in subsequent meetings, further rate cuts are on the table.

So, the point is that the interest rates in the US are still at decade highs, and they will gradually come down, which means the impact of high interest rates in the last more than two years could still be visible in the economy, with a rise in unemployment rates and probable recession in the US economy.

In one of the articles I read, a few rate cuts are not going to prevent a recession. The average recession is 10 months, and it takes something like a year before Fed cuts actually start to give a boost to the economy.

So, it is not that the moment the US Fed cuts the interest rate next month, everything in the US economy will become good and the US economy will be completely out of problems overnight.

Yes, the stock market can temporarily jump, as in the short term, market movement is based on sentiment.

Just to conclude, the point is that if the unemployment rate in the US does not fall, it can trigger panic in the US market because the US market has already priced in the majority of positive news from the rate cut.

Nasdaq has already zoomed 10% in the last three weeks, and even Indian markets are trading near all-time highs. Also, inflation in the US is still at 2.9%, which is above the target of 2%, and it's not easy to reduce inflation after a point as it gets very sticky.

So, the US Fed is hoping that in the best case, they would have a soft landing where inflation would fall below 2% without having major economic pain and without spiking unemployment rates. But if that does not happen, the US market can see a correction.

As far as Indian markets are concerned, although we are extremely resilient now and do not have much dependence on the US market, any negative event in the US will trigger concern over the Indian markets as well.

This is mainly because the majority of positive news...has already been factored into the Indian markets. So, in case there is some correction in the US market, it can lead to a correction in Indian markets as well, especially in midcap and small cap segments, which have already seen a crazy rally in the last few months.

But having said this, I don't think the correction in the Indian market would be deep, especially when Indian investors are standing like a pillar with their SIPs.

Overall, as an investor, the best way is to remain calm and patient. Don't try to time the market; rather, focus on the companies you are investing in and ensure that they are fundamentally strong. This way, in the long run, you will always emerge as a winner.

All the best!

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