What does Fed rate hike mean for Indian debt fund investors

The FOMC has listened to the market and has delivered a whopping 75-basis points hike in Fed Fund rates last night. This is the largest hike since 1994 and was in response to the scorching May Consumer Price Index. Another 50-75-bp hikes may be in the pipeline for July and September FOMC meetings.

The Fed has also revised the dot plot chart upward with the median Fed Fund rate expected to be around 3.4% by Dec 2022 up from 1.8% in March 2022 and 3.8% by Dec 2023, up from 2.75% in March 2022. The revised forecast is in line with market expectations of Fed Fund rates.

With this hike, the Fed seems to have earned their “hawkish-on-inflation” credentials back. That said, the US headline CPI will likely to remain above 8% y/y for some more months before starting to ease. This should keep the Fed vigilant on any further revision in inflation expectations.

US economic growth is expected to slow while the Fed will continue to tighten aggressively for the rest of 2022. This may probably make Fed’s soft-landing expectations hard to achieve, in our view.

Will this move embolden other central banks to bring in a bazooka to contain scorching inflation? That will be interesting to see and could be a possibility for some central banks where market participants have factored in the near-term path to normalization, in our view.

UST yields have eased in response to today’s FOMC hike. It may be a relief rally of some sort as market participants have unwound uncertainty premiums on FOMC move. The Dollar index has also eased immediately after the FOMC decision.

What does this mean for Indian bond yields?
Today’s rate decision by the FOMC is unlikely to sway RBI’s thought process in the near-term. That said, if the FOMC delivers an additional 75-bp hike in July meeting, then odds of a 50-bp hike in August MPC will rise, in our view. Recent jump in cut-off yields of 364-day T-Bill to 6.28% probably indicates increased market expectations of Terminal Repo Rate above 6% in the next 12-15 months.

We believe that 10-year benchmark bond yield should trade well within a range and below 7.62% – a technically important level. We believe that yields of long-term bonds are fairly valued and closer to their peak levels amid lighter trading positions and lack of incentives to sell at current levels. With 10-year bond trading close to its 200-month moving average, risk-reward ratio could be in favour of patient investors.

Investors looking to allocate fresh capital in fixed income assets should consider Target Maturity bond ETFs / bond index funds maturing in 2026 or later depending on their investment horizon. Yield curve of Target Maturity bond ETF / bond index funds is currently above 7% from 2025 onwards.

Risk to our view may come from sharp increase in crude oil prices and food prices in FY23.

(Dhawal Dalal is the Chief Investment Officer – Fixed Income of Asset Management Limited)


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