Will interest rates continue to rise? – The Financial Express

Clipped from: https://www.financialexpress.com/opinion/will-interest-rates-continue-to-rise/2212619/

The bond markets are pushing the central bank around and it is hard to see how/when this will stop

Of course, as we have all learned over the years, markets can stay irrational much, much longer than any of us can stay solvent, so, I guess, as always, the only certainty is continuing high volatility.

That the pressure on the rupee has increased sharply over the past couple of weeks is apparent, both to players in the market and, of course, from the sharp spread between the NDF and onshore markets. The 5-day average of the spread reached a high of 17 paise (at 1 month), the highest level since Mary 2020, before somewhat.

Significantly, RBI has been very active selling dollars to prevent rupee depreciation—completely reversing their activity over the previous several months. It must be that RBI is more concerned about inflation than it is letting on—rather than allowing the rupee to weaken, which would support exports, it preferred to sell dollars from its reserves to reduce INR liquidity, which has been in huge surplus. Domestic yields remain firm and the bond market appears definitively convinced that interest rates may be rising soon—they are certainly not coming down.

This should normally support the rupee, but a similar game is playing out in the US, with the 10-year yield rising sharply impacting sentiment across the board. Indeed, the day the rupee suddenly slipped (Friday, February 26), FPI outflows were huge—at more than $1.2 billion, they were the highest single day outflow since the trauma of March 2020.

Globally, inflation sentiment remains rocky with the US yield curve steepening steadily and raw material prices already raging—copper is close to its all-time high (set in 2011); oil is eyeing $70 a barrel, which is particularly tough for large importers, like India.

An important point to remember is that historically US interest rate volatility is one of the highest of any liquid asset class—higher even than commodities like copper and nickel; this clearly points out that forecasting interest rates is the most difficult game in town. To my mind, the reason for this is that new age central banks—Greenspan and subsequently—hate to raise interest rates so they find myriad ways of convincing themselves that they have inflation under control. Analysts, for related reasons—their employers make more money when markets are rising—also usually underestimate the pace at which interest rates can rise. [Incidentally, this is true in India as well; as recently as September last year, when inflation was showing signs of life, most analysts believed the uptick in inflation was temporary, driven by supply constraints during the lockdown; I suspect many have changed their tune by now.]

With this background, the correct risk-based approach in dealing with rising interest rates is to recognise that the distribution is skewed towards much higher (rather than much lower) rates, and assume that they will rise further and faster than even the most pessimistic analyst. There is already talk that the Fed may raise rates in 1Q23—while I don’t bet on anything anymore, banks and financial players need to protect against a rise much sooner than that.

Another piece of the rising interest rate puzzle is that US growth is expected to be very strong. To be sure, this may not translate into stronger equity prices because, as pointed out, raw material prices are rising and so corporate profits may not run parallel to growth. In addition to the proximate forces of potentially higher rates and potentially lower profits, there are also certain medium term forces that augur against continuing equity strength. First off is the focus on tax avoidance of not just the IT giants but multinationals in general, and the increasing likelihood that fiscal policy will move in the direction of more progressive individual and corporate taxation. Secondly, the increased focus on climate change is bound to impact equity prices, particularly as there finally appears to be a real seriousness on the subject. In any case, equities are already at extravagant highs—the PE of the S&P is at its third-highest in a hundred years and higher even than the level hit before the dotcom crash.

Of course, as we have all learned over the years, markets can stay irrational much, much longer than any of us can stay solvent, so, I guess, as always, the only certainty is continuing high volatility.

Coming back to the pavilion—that is, India—RBI appears to have won this rupee skirmish but market remains skittish; the 1 month NDF spread has come down, but, at around 10 paise, is far from comfortable. On the other side, the bond markets are pushing the central bank around and it is hard to see how/when this will stop. As long as US markets hold on, even with this high volatility, it is likely that the rupee, too, will be able to hold its own, ministered to by RBI and ultimately supported by rising domestic yields. But, when judgment day does come, as it surely will, the rupee will also take a dive.

But waiting for Godot is a foolishness: exporters should, rather than reducing their hedge ratios, incorporate some options into their portfolios; importers should—without fail—incorporate a trailing stop loss into their hedging strategy.

The author is CEO, Mecklai Financial

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