The year 2022 was, in a way, the turning point in economic thinking in most countries. The concept of de-dollarisation caught on. The Ukraine war triggered this move which was probably brewing for quite some time. But once Russia was kept out of SWIFT (the international payments system managed by USA) and their dollar assets impounded by the USA, the feeling was that the dollar was no longer a safe haven asset. There was need for the world to move away from the dollar. Even central banks all over the world are trying to increase their holdings of gold as part of the process of diversification of forex reserves. It did however turn out to be what Shakespeare would have said, “full of sound and fury” because the world remains dollarised even today.
In fact the US hegemony in the market can be savoured by the importance placed by the whole world on the Federal Reserve. The Fed has become the anchor for the entire ecosystem of central banks; and while the stance is that decisions taken are based on domestic conditions, one cannot ignore what the Fed does. If one is in the market, one can see that every statement made by any of the officials of the Fed have far-reaching consequences on bond yields. When they express a simple view on the timing of a possible Fed action which involves cutting rates in future, hiccups can be felt in the market when the direction indicated is not downwards. In fact, everything that can influence the Fed has an impact on how the bond yields move not just in USA but also other countries including India. Hence any movement in the inflation rate, howsoever marginal sends sharp signals to the rest of the world. Why should this be so?
The answer is that it is still believed that most global flow of funds are driven by the actions of the Fed. If the Fed sends any signal that it will not be lowering rates any time soon, there is panic in the market and the bond yields move up in the USA. This does not stop here but spreads to other countries. The Indian 10-year bond yield has been largely driven by the sentiments about the Fed. The link with the 10-year US treasury is very close.
The transmission process is simple. When the Fed decides not to lower rates, the interest rates firm up in the USA. This is a signal for investors to put their funds here as the returns are better. This in turn means that there are fewer funds moving to other countries, especially the emerging markets. It should be pointed out here that ever since the Fed went in for quantitative easing post the Lehman crisis, investment funds moved to the emerging markets because there were cheap funds to be had and invested in countries where returns were better. This was the time when the Fed funds rate came close to zero. The reverse happened once the Fed decided to increase interest rates in 2022 and 2023. And this policy went with quantitative tightening where no fresh bonds were purchased by the Fed though the rollover took place.
Therefore, the interest rate signalled by the Fed is very critical for every market player outside the USA too. When the Fed was increasing rates, it was accepted by the market. But ever since the pause was taken when inflation appeared to be coming down, the question raised was as to when the Fed would lower rates. The published dot plot shows that there could be three rate cuts this year totaling to 75 bps or thereabouts. But with there being uncertainty on inflation, the signal sent by the Fed is that it is not in a hurry to lower rates and would not like to be caught in a situation when it lowers rates and sees inflation rising.
Theoretically when rates in US are high or are increased, the dollar strengthens which in turn also means that other currencies weaken. This gets reflected in the dollar index which goes up. Weakening of other currencies mean that there is depreciation which goes beyond the fundamentals which are defined by demand and supply for dollars. Depreciation normally could prompt some central bank action which will, in turn, lead to a more hawkish view being taken by them on interest rates. This automatically keeps interest rates elevated.
While the three rate cuts starting June was a story crafted by most analysts in the west, the Iran-Israel conflict has raised doubts on the same. In fact the conventional thinking now is that the rate cut will get deferred to a later date and it could be in July-August. Also the quantum of rate cuts has now come down to one or two totalling 50 bps.
India has been affected by these swaying sentiments both in the bond market as well as currency movements. There is a dualistic trend in the money market where short term yields tend to be linked with the state of liquidity in the system. However, the 10-year bond is tending to take cues from the US treasury yields. This will continue until such time as the Fed actually starts lowering the policy rate.
The currency on the other side has come under pressure with the dollar becoming stronger. The fundamentals that are driving the rupee appear to be firm with the prospects also looking positive with the FPI flows expected to accelerate post June. Yet the pressure is palpable by the day and the RBI will have to continue playing an active role to curb excess volatility when it erupts.
This picture is not very different in other countries too where the linkage with the Federal Reserve and hence the US economy cannot be severed. This is because of globalisation linking all financial markets with the flow of investor funds which leaves a strong imprint everywhere. This is why one cannot ignore what the Fed does even though the targeting of inflation, which varies across geographies, is more localised in nature if one ignores crude oil and its impact.
The author is Chief Economist, Bank of Baroda and author of ‘Corporate Quirks: The Darker Side of the Sun’. Views are personal
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