The last I wrote to all of you was about the budget, where the focus was on Fiscal Policy. Today let me get to the basics of monetary policy. Monetary policy refers to the actions undertaken by a country's central bank to control the money supply and interest rates to achieve specific economic goals. The trinity objectives of monetary policy are:

 

• Price Stability: To maintain a stable inflation rate, reducing uncertainty and promoting long-term investment.
• Employment: To achieve and maintain a high level of employment in the economy, lead to increased consumer spending, driving economic growth and corporate profits.
• Economic Growth: To foster conditions conducive to sustainable economic growth, enhance living standards, and increase the overall wealth of the population.

 

There are several tools available at the disposal of the central bank, ranging from open market operations (OMO) and interest rate changes to quantitative easing. Most prominent, however, is the key interest rate set by central banks, which influences the cost of borrowing throughout the economy.

 

Effects of a Rate Increase typically include

- Increases cost of borrowing

- Can slow economic growth

- May strengthen the currency

- Often negatively impacts stock prices

- Tends to decrease bond prices (yields rise)

 

And the converse holds true for a rate cut.

 

Interestingly, markets often react to anticipated rate changes before they occur. This is because financial markets are forward-looking, and asset prices reflect expectations of future economic conditions and policy decisions.

 

Now, if you are following the news (which I am sure you are!!), you know the reason why we are discussing all this.

• Japan, after maintaining ultra-low or negative interest rates for years, the Bank of Japan hiked its rate to 0.25%, its second hike in 17 years.
• Rising unemployment in the US, with the rate increasing to 4.3% in July. This marks the fourth consecutive monthly rise.

 

This news comes against the backdrop of increasing geopolitical tensions in the Middle East and the US Fed maintaining its stance and delaying the much-anticipated rate cut. 

 

Interestingly, the Japan rate hike effect is not limited to the consequences mentioned above. It is reminiscing of BUTTERFLY EFFECT, owing to the Yen Carry Trade. 

 

 

The yen carry trade is a popular strategy where investors borrow money in Japanese yen (which has had very low interest rates) and then invest that money in assets with higher yields. The idea is to profit from the difference in interest rates, minus the cost of borrowing. Japan's ultra-low interest rates have made this strategy profitable for many years, as investors could borrow cheaply and invest for higher returns elsewhere.

 

Now, what happens with the rate hike,

• the borrowing cost has increased
• strategy becomes less profitable
• significant movements in currency markets and asset prices globally
• significant reshuffling of global investment portfolios
• possible reduction in global liquidity as carry trades unwind

 

There is a potential chain reaction in the making, if many investors exit at once, it could trigger further yen appreciation and more unwinding, potentially causing a snowball effect. This can be exacerbated with BOJ halving monthly bond buying in Q1 2026 and the possibility of another rate hike this year not being ruled out.  

 

Fears of a US recession following weaker-than-expected jobs data

 

Concerns about a potential US recession are growing, with Goldman Sachs raising recession probability to 25% for next year. Sharp market declines globally, with major US and European indices down 3-4% in a single day.

 

The Nasdaq, S&P 500, and Dow Jones all fell around 3-4%, while Japan's Nikkei saw a massive 14% drop. However, it's not a surprise, if you remember this piece "Are you ready for the DENT in your wealth". Economist Harry Dent predicted a 98% crash in Nvidia, a 92% drop in Nasdaq, and an 86% in S&P. Though the exact numbers may differ but we cannot deny the global market meltdown.

 

Tech stocks have been hit particularly hard in recent weeks as investors pull back from artificial intelligence companies amid questions about when the emerging sector will deliver profits. Nevertheless, it is not a good approach to read too much into a single data release. ISM Services data is encouraging.

 

Sharp market declines globally, with major US and European indices down 3-4% in a single day. The Nasdaq, S&P 500 and Dow Jones all fell around 3-4%, while Japan's Nikkei saw a massive 14% drop.

 

The US is the world's largest economy, and its economic health significantly impacts global markets. US economic indicators often set the tone for global market sentiment. US interest rates affect global capital flows. Anticipated rate cuts in the US could lead to increased foreign investment in Indian markets, boosting stock prices and the rupee. US economic data and Federal Reserve policies influence the strength of the US dollar.

 

Specifically, for India, Changes in the USD-INR exchange rate affect Indian importers, exporters, and companies with foreign currency debt. US economic health directly impacts the demand for Indian IT services. The US is one of India's largest export markets. A stronger US economy typically means increased demand for Indian goods and services.

 

Imagine playing Jenga. Blocks from a solid tower must be removed and stacked without collapsing. This game perfectly illustrates financial market collapse mechanics. At the start of the game, the tower is stable like the financial market under economic stability. The tower gets unstable as players remove and add blocks (key developments).

 

Each block (poor employment data, in the present context) removed increases risk. A tower may stand, but vulnerabilities appear. Signs aren't always obvious till the system is under stress. The collapse is sudden and dramatic, a culmination of all the risks taken. The falling blocks cause a chain reaction, toppling the entire structure. These events have created interesting dynamics in financial markets, affecting currency exchange rates, international fund flows, and the relative attractiveness of different markets and asset classes globally.

 

These global headwinds definitely are a cause of concern for Indian investors, too. With the change in sentiment, one is cautious about the "Buffett Indicator" (total market cap to GDP ratio) for India hitting an extremely high level of 150%, suggesting overvaluation. Moreover, as I write, RBI, in its Monetary Policy Committee (MPC) meeting, is to decide what stance to maintain amidst these global developments, something to keep an eye on. The Reserve Bank of India (RBI) often considers US Federal Reserve actions when making its own monetary policy decisions.

 

But, here, I would like to draw your attention to something peculiar about the Indian markets and it’s not only that, India's economy has consistently demonstrated remarkable resilience in the face of global economic challenges, particularly those originating in Western economies.

 

In the post-COVID era, Domestic Institutional Investors (DIIs) have indeed emerged as a significant driving force behind the Indian stock market, especially in times of global uncertainty. Every time when Foreign Institutional Investors (FIIs) pull out funds during global crises, DIIs often step in to provide market stability. This was evident during recent global events like the COVID-19 pandemic and the Russia-Ukraine conflict.

 

Additionally, DIIs, including mutual funds and insurance companies, are a source of consistent flows that provide a steady source of liquidity and support for Indian equities. Increasing financial literacy and the rise of systematic investment plans (SIPs) have led to more retail investors participating in the market through DIIs, further strengthening their influence.

 

DIIs typically are believed to have a longer investment horizon compared to some foreign investors, which helps in reducing market volatility. It is this growing strength of DIIs that has helped reduce the Indian market's vulnerability to sudden foreign capital outflows.

 

My dear readers, while the market volatility is concerning, it's important to maintain perspective.

• Corrections are normal: Markets don't go up in a straight line. Periodic pullbacks are healthy and can create buying opportunities.
• Stay invested but be cautious: Avoid panic selling, but also be wary of trying to catch a falling knife.
• Valuations becoming more reasonable: The correction is bringing some markets closer to long-term average valuations.
• Focus on the long-term: Short-term volatility shouldn't derail your long-term investment strategy if it's properly aligned with your goals and risk tolerance.
• Consider a staggered approach: If you have cash to invest, consider deploying it gradually over time rather than all at once.
• Focus on quality: Prioritize companies with strong balance sheets, consistent cash flows, and competitive advantages.
• Stay informed but don't overreact: Keep up with market news, but avoid making rash decisions based on short-term volatility.
• US recession fears may be premature: While there are signs of slowing, the US economy is still growing. The latest GDP data showed 2.8% growth in Q2 2024.

 

As we see the effect of unwinding of yen carry trade settles, the markets are going to bounce back (with a probability of 1 in the long term). Meanwhile, don’t ignore lessons from previous market crashes and rebuild your portfolios.

 

Happy Investing!

 

Best Regards
 
Dr. Tarunika Jain Agrawal Ph.D. 

Alpha Research

 

Disclaimer

The above views are our expectations of the economy, market and investments. The views may or may not play out accordingly. You are requested to do your own due diligence before making any investment.